The lure of penny stocks is hard to resist when you’re starting out as an investor. Today, I’m going to look at why newbies should consider bypassing the junior market completely.
What’s the pull?
It’s not hard to come across stories of investors making millions on company shares that were once trading for a few pence. This is, after all, exactly what happened to fast-fashion play ASOS. Trading at 4p a pop back in 2003, the very same shares now change hands for almost 3,200p. They were once above 7,000p!
The fact that stocks also trade at so low a price is often interpreted by new investors as a good thing since it allows you to buy what appears to be a huge initial position. A stock trading at 1p per share, for example, will give you a holding of 10,000 shares if you were to invest £100. Of course, this is irrelevant. It doesn’t matter if you have 10 shares or 10,000 if their value sinks to zero.
But there are other reasons to steer clear.
The first is based on probability. For every ASOS, there will be thousands of businesses that merely tread water or fail completely (taking your money in the process). Winners spring to mind so easily due to survivorship bias.
To use an analogy, many will know that Usain Bolt holds the record for the 100m sprint. Few, however, will remember the names of those he beat to set that time (9.58 seconds), those who tried but failed to qualify, or know those who called time on their promising running career due to injury.
Second, many small companies see a stock market listing as a way of generating cash to make their blue-sky plans a reality. Unfortunately, just getting a business to profitability can take longer than expected, if it happens at all. This requires management to ask for more money to keep the lights on. More shares are then issued which, in turn, dilutes the value of those already held.
Third, penny stocks tend to be illiquid (hard to sell quickly) and, consequently, volatile in price. That’s less of an issue when markets are behaving themselves, but it can be an unmitigated disaster when they’re not.
A rush to jettison a minnow by investors is likely to result in a huge drop in price that doesn’t reflect its intrinsic value. If you’re actually able to sell, you may get back a lot less cash than you put in.
A better plan
Rather than diving in at the deep end of, I think all new investors should keep things as simple as possible.
By far the best way of doing this, at least in my opinion, is to invest in cheap funds that track the market return. You won’t get wealthy in a hurry, but you won’t lose your shirt either.
As an example, £100 stuffed in a fund tracking the FTSE 100 delivering a 7% annual return over 30 years would grow to £761 (excluding fees). Now think about if you were able to invest significantly more than £100 over that period of time.
Investing in penny stocks can be a lucrative endeavour, but anyone contemplating entering this arena should be absolutely sure they understand the risks before doing so. If in doubt, steer clear.
Paul Summers has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.