“Retail investors like penny stocks”. This has to be the understatement of the century because retail investors not only like penny stocks, they really LOVE penny stocks! Penny stocks seem like the opportunity for many small investors and traders to improve their financial condition overnight (similar to gambling :D). It is much easier for a stock worth Rs. 10 to double compared to a stock worth Rs. 10,000 right? WRONG! Before we understand why penny stock won’t make you rich, let’s dive into the reason why retail investors get enticed towards penny stocks.
Why do penny stocks entice retail investors?
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Retailers think the more stocks you own, the better are your chances of wealth creation!
It might seem logical that buying 100 stocks of one company is better than buying a single stock of another company. Of course, 100 is so much larger than 1, right? WRONG! The higher number of stocks which you own have nothing to do with the returns which you will make in the market. In fact, just by owning more stocks, doesn’t even mean that you are a bigger shareholder of the company!
Imagine a company which has a market capitalization of Rs. 1 Crore. This company has a share price of Rs. 10,000 each. If you have one stock of this company, you have a 0.1 % shareholding of this company. On the other hand, if a company has a market capitalization of Rs. 1 Lakh Crore & the individual share price of the company is Rs. 100, you will only have a 0.000001% shareholding of the company even if you own 100 stocks of this company. The price of the stock is not the same as becoming a bigger shareholder in the company! To learn more about such myths which retail investors believe, visit this article – 13 investment myths which retail investors believe!
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Penny stocks look undervalued
Penny stocks typically look undervalued to retail investors. One of the most common phrases heard about a penny stock is “The stock is already at Rs. 5. How much further can it fall?” The answer to that question is : A LOT! There are some stocks in the NSE which are currently trading at under Rs. 1! Imagine buying a Rs. 5 stock which turns into a Rs. 1 stock. That would be an 80% loss on a stock which many people think cannot fall much.
Retailers need to understand that just because the stock price is small, doesn’t mean that it is available for cheap. To understand the value of a stock, the investor needs to look for the business of the company and understand the fundamental value of the company. One such simple method to analyze a company is the P/E ratio of the company. To learn more about understanding the fundamentals & choosing your first stock, visit this article – How to choose your first Stock?
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Penny stocks give hopes to people for a miracle
Most people get enticed by the hopes of making a multibagger return from penny stock just like a gambler hopes to win the jackpot by buying a lottery ticket. Someone would probably win the lottery, but the math would suggest that it won’t be you! There is an astronomically small chance of winning the lottery, similarly there is a miniscule chance of winning the jackpot by buying penny stocks.
It is much more prudent to invest in good companies rather than running after penny stocks in the hope of a miracle.
But didn’t seasoned investors get rich from penny stocks?
Many people have heard stories of investors becoming rich by buying penny stocks. The most famous story is of the stock Titan which became a huge multibagger providing multi-fold returns to its investors! However, what people miss out when telling this story is that – Titan provided multibagger returns because it was a good company, not because it was a penny stock. It also happened to be a penny stock at the time. Also, considering the inflation which has happened over the years, a penny stock in the 1990s would be a lot more valuable than penny stock today.
Imagine if the board of ITC were to announce a stock split of 10:1 today, the price of the stock would fall to Rs. 31.5 (at the time of writing). Essentially, this would classify the company as a penny stock. However, the fundamentals of the company would not have changed even one bit due to the stock split. The value of the company remains exactly the same as it was before the stock split. A company can be a good company despite being a penny stock, but most penny stocks are too dangerous for retail investors to invest. To learn more about this, visit the article – Why stock split doesn’t change the value of the company?
Why penny stocks won’t make you rich?
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Many penny stocks are pump & dump schemes
Penny stocks generally have a low share price AND a low market capitalization which makes them an easy target for pump and dump schemes. Small fund houses with a few crores to spare sometimes run operations of these stocks where they artificially cause the price of the stock to rise, enticing retailers. By the time retailers enter, big players would be already out with their sweet profits!
Most bigger stocks (Nifty 100/ Nifty 500) are big enough to resist a move from a big player due to their high market capitalization. You will almost never see these stocks hitting circuits or giving massive moves intraday. This is the reason why retail investors should only invest in stocks which have a high market cap, not the stock which looks “cheap”.
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Penny stocks are get less media coverage
Most penny stocks are small and unknown companies who do not get any attention from the media. This creates a bad situation for investors since the company is not under the scrutiny of journalists & media centers. Now you must be asking, how does that matter? It matters because you will not get to know any key information regarding these companies! It matters because it becomes very easy for a small company to manipulate its results to make their shareholders happy or to commit scams/frauds. Many times, successful companies end up losing their major value overnight on the news of a scandal. Such penny stocks can keep on committing frauds without you even realising that something fishy is going on. By the time you realise it, it might be too late!
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No big funds invest in penny stocks
Penny stocks do not have any support from big funds. Most big funds are not interested in investing in a company which doesn’t have a proven track record or a company which has been under their scanner for a long time. Big funds even consider these companies equivalent to gambling due to the high risk involved in such companies. This means that the stock price is only being supported by promoters and retailers. The lack of strong hands supporting the stock makes them extremely dangerous and unpredictable to invest.
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Penny stocks don’t move based on their fundamentals
Last but not the least, penny stocks do not move based on their fundamentals. Penny stocks generally move based on news or are driven by big funds who want to pump and dump the stock and make quick money. Basically everyone including big funds and retail investors are in penny stock for one and only one reason – to make quick money! Nobody has invested in a penny stock because of its good fundamentals. This makes it extremely difficult to predict the future of such a stock because it doesn’t move based on fundamentals. Even if such a company is improving its business, it can still be a target of pump and dump schemes by big funds!
Conclusion
Penny stocks are too risky for retail investors to invest. Their low market cap combined with their lack of holding by big player can make them some of the most volatile stocks in the market. It is akin to playing a lottery where your only investment strategy is – HOPE! And that’s not a good strategy for serious retail investors who want to create their wealth in the stock market. To learn more, visit this article – Why retail investors should stay away from investing in Penny Stocks?
Please note that there have been some penny stocks which have become multi-baggers over decades but such cases are extremely rare. Retail investors are better off to wait for these companies to prove themselves first and then invest in the company.
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DISCLAIMER : I am not a financial advisor. I am not for or against any company which I have mentioned in this article. All the information provided here is for education purposes. Please consult a financial advisor before investing.
Contact me at investmentabshuru@gmail.com
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