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Should We Invest In Penny Stocks?

The term “penny stocks” is often being thrown around in the media. But do we really know what it means?

The honest answer is there is no formal definition of a penny stock. Having said that, most people who use the term commonly refer to stocks that have either or both of the following two characteristics.

The first characteristic is a small market capitalization. This means that the total dollar value of all the company’s outstanding shares is small compared to the average listed company. In Singapore, this could mean a company that has a market cap of under S$10 million.

The second characteristics is a very low share price. In Singapore’s stock market, it typically refers to a stock that is trading at less than 20 cents. However, again, this is not a hard and fast definition and the cut-off number usually varies depending on whom you ask and in which market.

But in any case, a penny stock is a company with a small market cap and/or a low stock price.

The risks of investing in penny stocks

So, the big question now is should we consider investing in penny stocks? It is worthwhile noting that penny stocks tend to carry higher risks for investors compared to larger companies.

The first and probably biggest risk when investing in penny stocks is the likelihood of encountering high price volatility. Because the volume of shares traded for penny stocks can be small, a large shareholder who wishes to sell her shares may cause a huge drop in the price of the shares, as there are relatively few buyers in the market.

Obviously, this works both ways, meaning that if a penny stock suddenly gets a little bit of attention, and investor interest increases, there may be a huge uptick in the company’s stock price.

On that note, because fewer people trade in penny stocks, liquidity is also low. That is another risk. Low liquidity means it may be difficult for you to sell your shares in a company at your preferred price as there are only few buyers in the market.

Another important risk concerns the company’s size. Companies that are small in size tend to be riskier than larger companeis. This is because a small company would usually have been in operation for a shorter duration, and its business may thus not be proven yet.  Also, smaller companies may not have the financial muscle of their larger counterparts to withstand any shocks.

Having said that, a small cap company that is new in an industry may have greater maneuverability to disrupt the market through new business models and technologies.

The Foolish bottom Line

Many investors have the misconception that penny stocks are better investments because of their small market cap and longer runway for growth. But small cap companies also come with their own set of risks.

The risks can stem from the shorter operational history or unproven business record of a small company. The relative lack of public information regarding smaller companies may also make them harder to invest in.

Although there may occasionally be great long-term growth companies hidden in the penny stock world, investors should always proceed cautiously when investing in them. Keep both the potential rewards and risks in mind.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Jeremy Chia doesn’t own shares in any companies mentioned.