The massive rebound in markets over the past few months has seen a lot of new investors signing up for a slice of the action. And who can really blame them when you have many coronavirus-related penny stocks multi-bagging in value?
Is this an easy route to riches? Probably not, and here’s why.
The problem with penny stocks
Now, don’t get me wrong: you certainly can become very wealthy if you buy the right minnows at the right time. But there’s the rub – identifying penny share winners and timing your purchases early enough is fiendishly difficult given the huge number of factors that determine whether a company succeeds or not. A potentially great business doesn’t always translate to a great investment.
As well as being hard to sort the wheat from the chaff, those wanting to invest in this part of the market must also be aware of how ‘illiquid’ penny stocks can be. Liquidity means how easy it is to buy or sell something without affecting its price. Illiquidity can be great when the herd wants to buy (causing shares to jump) but a nightmare when everyone sprints to the exit. Forced sellers must often accept prices that, in normal circumstances, they would laugh at.
The huge volatility seen in penny stocks is worth remembering right now. It would be wrong to assume that many of those coronavirus-linked stocks that have soared over the past few months won’t suddenly tumble in value. This may be due to another broad market crash, traders banking profits, or news that the products they supply are no longer needed or ineffective.
It doesn’t stop there with penny stock drawbacks. Young companies, particularly those in high-risk, high-reward sectors, often need to tap the market for more cash just to keep the lights on. Sadly, this isn’t always forthcoming and many are forced to fold, making the shares worthless.
Make no mistake, penny stocks can make you rich but they’re also far more likely to leave you poor.
A better solution
Rather than attempt to find the needle in a haystack, there are other, safer ways of tapping into healthcare or biotechnology.
For the former, you could always buy a FTSE 100 juggernaut like AstraZeneca or GlaxoSmithKline. For the latter, you can buy active funds that specialise in this part of the market. Two of the most popular are Biotech Growth Trust (LSE: BIOG) and International Biotechnology Trust (LSE: IBT).
Another option is to buy passive funds that focus on these themes. Like their active equivalents, these give instant diversification to holders by investing in a large number of stocks. And since they’re only out to track rather than beat indexes, the fees are a lot lower.
Examples include the iShares Healthcare Innovation UCITS ETF. The iShares Ageing Population UCITS ETF, which gives exposure to companies providing products and services to those in their golden years (many of which will be healthcare-related), is also worth considering. Both funds have ongoing charges of just 0.4%.
A punt on coronavirus-related penny stocks might make you rich but there’s a very real chance it will go wrong. If you’re tempted, I’d suggest only using money you can afford to lose. Put the majority of your capital to work in far less risky options.
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Paul Summers has no position in any of the shares mentioned. The Motley Fool UK owns shares of and has recommended GlaxoSmithKline. 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.