5 pitfalls to avoid when investing in penny stocks
Taking a plunge into the vast unknowns of the stock market can be scary for new retail investors, especially for riskier investments like penny stocks. However, there are some commonly known pitfalls that one can avoid in swing trades to minimise risk.
While investing in long-term and blue-chip stocks are relatively easier, investors often slip up when it comes to highly volatile and unpredictable penny stocks. Stocks of a small company that trade for less than Rs.10 per share are typically referred to as penny stocks. They are less liquid than blue-chip stocks and are highly volatile and speculative due to their low prices.
Some examples of penny stocks that gave huge returns to their investors in the past year are Citizen Infoline, Swiss Military Consumer Goods, IL&FS Engineering and Construction and Tine Agro.
As said by Warren Buffet, “Risk comes from not knowing what you are doing.”
So let us look at how to pick up the best penny stocks to buy and some common mistakes to avoid in order to minimise risk.
- Too much diversification
Diversification works great when it comes to minimising risks for long term investing. However, when it comes to penny stocks, diversification prevents investors from earning meaningful returns due to their low prices. Having a wide range of stocks limits the investment in each stock and so even if a stock sees a monumental rise in price, the return to the investor will be limited.
Moreover, it also makes it easier for investors to monitor a small basket of penny stocks and exit at the right time as opposed to screening several stocks.
2. Overdependence on penny stocks
Investing in the right low-priced stocks can bring phenomenal gains in the short term. However, one should be mindful of not overinvesting in these notorious stocks. These high-risk stocks should not form more than 10% of the total portfolio to minimise risk since penny stocks are highly volatile and speculative.
3. Not exiting at a high
Investors cannot afford to sit back and wait for returns once they have figured out the best penny stocks to buy. One should keep in mind that penny stocks are for short-term investing and it does not always pay off to hold them for long periods.
The following chart depicting the performance of Bilcare Ltd stocks clearly shows the volatility of penny stocks and the importance of selling them at their peak.
Thus, investors should set a target for exiting the stock and closely monitor the movements of the stock. Once it reaches the desired high, it is wise to sell it off and book profits without waiting any further.
4. Buying illiquid stocks with low volume
When dealing with penny stocks in swing trade, it is of utmost importance to be able to sell them off when the price rises. A common mistake that investors make that lead to huge losses is buying large quantities of penny stocks that are trading in low volumes in the market.
The investor should do his due diligence to ensure that the stock is liquid and actively trading in the market. Such data is readily available on various websites including NSE India. This way, one can ensure that there are buyers in the market when the stock reaches its target price.
5. Falling for promotional tips
Many times investors come across promotions for various penny stocks claiming that they are the best penny stocks to buy today. One should believe in such tips with caution and not fall for such promotions blindly.
“Forecasts may tell you a great deal about the forecaster; they tell you nothing about the future” - Warren Buffet.
Often, such tips are posted by other investors who are trying to generate buyers in order to dump their junk stocks. It is advisable to trust the numbers and play it safe when it comes to low priced stocks.
Keeping in mind these 5 common pitfalls, investors should be able to navigate the world of penny stocks safely. However, one should always prepare for a certain amount of loss while investing in these high risk, high reward stocks.
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