Penny stocks: Risks and rewards of investing in low market cap shares 

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Investors, traders, especially the retail buyers and new-age individuals have an ardent interest in penny stocks investment, primarily due to the low market prices and expectancy of higher returns on a small-sized investment in a short run. Fundamentally, all the market-tradable securities possess a certain number of benefits, as well as risks as the shares representing an enterprise on a bourse are affected by a number of factors.  

Of the numerous components influencing the share prices, some can be evaluated and controlled, while there are a few components that are entirely unwarranted and cannot be controlled even by the management of the company. As far as the risk-to-reward ratio of investing in shares is concerned, the return on investment and the potential risk of losses is subject to shares that can’t be generalised for all.  

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There can be some factors that are unfavourable to a particular enterprise but are supporting the nature of work of another company. Moreover, due to the varied size, scale and nature of operations, each business and industry has its own pros and cons.  

The conventionally experienced traders and long-term investors do incorporate and evaluate a vast size of possible factors that can affect the market prices of the securities in the near term to have a more meaningful projection. The new-age investors and the fresh breed of traders largely focus on maximising their gains by investing in penny stocks, opening their trading account with discount brokerages, and limiting the holding period for a week to a couple of months.  

With the ample number of opportunities available in the market, investors of all categories get the securities of their desired risk potentials and expected rate of return. But when it comes to investing in penny stocks, the risk and return ratio often gets disturbed due to the heightened uncertainty of the share prices.  

With penny stock investment in focus, we take a look at benefits and limitations of investing in these low market cap shares. 

Benefits of penny stocks investment  

With the low market prices of penny stocks, an individual has a fair chance of buying more number of shares in a fixed amount as compared to buying large-cap or mid-cap shares in the same quantum of money.  

A marginal rise in the absolute value of the shares can result in huge relative gains. For example, a gain of GBX 2 on a share priced at GBX 10 translates into a 20 per cent gain on the investment. 

Therefore, an investor can quickly recognise a gain of GBX 2,000 (excluding the transactional costs) if he has invested a sum of GBX 10,000, buying 1,000 shares

On the contrary, an absolute gain of GBX 2 on a share with a market price of GBX 1,000 only translates into a relative rise of 0.20 per cent. So, if an individual has invested GBX 10,000 for buying 10 shares can only realise a profit of GBX 20.  

Out of the bunch of penny stocks, there are some securities that multiply exponentially, emerging as the potential large-cap company in years ahead.  

Limitations and disadvantages  

  • With a momentous gain in shorter intervals, penny stocks predominantly contain long range limitations and disadvantages. 
  • The low market capitalisation and the subsequently low proportion of shareholders makes it hard for an investor to buy or sell a desired quantity at a particular time. For instance, an individual who bought 1,000 shares of X company may not get a buyer at the right time when the market price of the shares has gained say 30 per cent in a day. 
  • Speculation is widely done in penny stocks, as a big-ticket investor or a group of large investors can affect the liquidity by holding the shares, effectively freezing the trade at the time of price rise or fall. 
  • Low trading volumes in the shares often gets flagged by the exchange or the regulator. In several cases, exchanges increase the surveillance on penny stocks to eliminate the possibilities of skulduggery. 
  • Less information and reporting about the underlying company behind the penny stocks makes it quite difficult for the investors to adjudge the ongoing happenings at the enterprise level. Even after the obligatory disclosures, small-sized companies often miss out on communicating the details of a potential threat or a revenue loss. 
  • High volatility, low liquidity and a range of uncertain events associated with low market capitalisation companies, develops more risk for the traders dealing in penny stocks. 
  • Penny stocks possess relatively high amounts of risk, largely due to the non-disclosure by the enterprises. 

 

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