Penny stocks investing: 5 factors to consider

Summary 

• Penny stocks are cheaply priced stocks having a low market capitalisation
• Penny stock investing has risen in popularity in recent years due to its potential to give big returns, however, they are considered a very risky investment choice
• Key factors to consider prior to investing in this type of equity includes stock picking strategy, investment amount and other factors

Penny stock investing is a popular investing strategy where investors seek out cheaply priced stocks that can be bought in bulk at a relatively lower price compared to blue-chips, in the hopes of certain stocks emerging as multibaggers.

Penny stocks in the UK are classified as equities that typically trades at a market price below £1 or have a market capitalisation less than £100 million.

Such types of equity investments can be attractive due to its potential high returns and low price; however, they are considered as a risky investment due to major stocks being illiquid, also susceptible to scams such as pump and dump methods and having high price volatility.

Due to penny stocks being smaller sized and relatively younger companies, they also have limited information available for investors to research the company. Investors seeking to benefit from a strategic penny stock investing method must therefore consider several factors before investing in penny stocks.

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In this article, we take a deep dive into 5 key factors one should take into account prior to investing in this type of stocks:

1. Investment amount: Due to the risky nature of penny stocks, an investor should only invest an amount into this type of instrument they will feel comfortable with losing. Thus individuals must refrain from investing large amounts into penny stocks. A general rule of thumb is to invest up to 10 per cent of one’s equity linked portfolio investment amount, however that figure can be adjusted depending on the individuals’ personal preferences.
2. Consolidate, not diversify: Since such stocks are cheaply priced, bulk buying a few stocks can provide an investor with a possibility of having higher returns rather than diversifying across several stocks.
3. Investment horizon: As penny stock investments are usually a shorter-term investment strategy due to their high-risk high-reward feature. Investors should be ready to trade and capitalise on sudden favourable price movements of their stocks to yield the best results.
4. Stock picking strategy: Due to the illiquid nature of such stocks, investors should ideally look for stocks that have higher traded volumes. Also, a lot of such small companies can easily go bust, hence investors must track financial ratios such as liquidity, leverage, valuation and performance ratios, and other financial indicators to gauge the overall health of the company prior to investment.
5. Investor behavioural changes: A common investment behaviour emerges when investors make early gains on risky investments, they tend to make errors due to their new found confidence. However, the key to remaining successful in penny stock investing is to maintain one’s investment strategy and remain level headed despite early successes or losses.

In addition to the above, an investor should also identify their own risk threshold and their investment goals to maximise their investment and mould their portfolio according to their specific needs.

Also Read: FTSE penny stocks: 3 shares below 10p gain up to 250% in 2021