Summary

• Penny stocks are securities of companies with low market capitalisations, with higher risks
• Small investors are generally lured towards these low-priced stocks.
• Experts advise caution while investing in these stocks.

Even as penny stocks are prone to high risks, they are known for their enticingly low prices and manage to allure small investors. At the heart of their undeniable allure, lie attractive returns that some of the penny stocks deliver every now and then. However, for prudent investing, these stocks should always be traded with a great deal of caution, owing to their risky nature.

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We must be properly acquainted with penny stocks before starting with the rules for investing in this risky segment.

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What is a penny stock?

A penny stock is generally referred to a stock of a company with low market capitalisation, which is valued less than a dollar. Such stocks lack adequate liquidity in the marketplace. Generally, investors find it difficult to sell these stocks in absence of enough buyers at a given time.

READ MORE: Five Penny stocks that created buzz on the ASX today

Since penny stocks have low liquidity, investors find its challenging to find a price that accurately reflects the market scenario.

On that note, check out these five golden rules for investing in penny stocks:

Big no to too many penny stocks

Investors should not be extravagant while investing in penny stocks since such stocks carry higher risk. According to several experts, an investor’s portfolio should not have more than 10% allocation to penny stocks.

Typically, penny stocks offer their investors higher potential for profits as they are highly volatile. But these stocks also come with a heightened level of risk.

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There are also chances that investor may lose their investment or more if they buy on margin.

Diversification doesn’t work here

The principle of diversification is generally followed while investing in equities, however, it does not work quiet well with penny stocks. Experts advise to limit your exposure to just a handful of such stocks.

Investors must always have realistic expectations from such stocks since these are high-risk investments with low trading volumes.

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Similarly, you should not try to average your purchases. If you have purchased a penny stock at $4 and it is now trading at $2, you must not try to cover the loss by purchasing more. you bought a share at $6 and it is now trading at $3, do not try to average out your purchase by buying more of it. It may only add up to your losses.

Are you using a stop-loss?

A stop-loss helps penny stock investors to exit the market if it moves in a direction opposite to what they had anticipated. Once the price limit set up by the stop-loss orders is reached, automatic-sell of securities is triggered in the system.

Short-term gambit

There is no point in holding a penny stock forever as it carries inherent risk because of high volatility. So, investing in such stocks should be a short-term affair and investors should not invest and forget their penny stock holdings. Investors should book complete or partial profits if the stock sees a steep surge.

READ MORE: Five hot penny stocks on ASX 200 delivering high returns today

Stock with higher trading volumes

Investors should always buy penny stocks with reasonably higher trading volumes since they are generally thinly traded. It helps investors to offload these stocks easily in case they want to make an exit. One must not only look at a day’s trading but consider the monthly average of trading volume.

Finally, one should never blindly believe in anyone and everyone when it comes to penny stocks. There are several online investment portals that are abuzz with information and advice on these stocks. You must always conduct a detailed research before taking a call on these stocks.