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Tuesday, March 5, 2024

The risks investors take when buying penny stocks

For many investors, stocks that cost less than one euro sound like a tempting investment. The supposed bargain papers, however, have enormous risks that are often extremely underestimated by many investors.

• Visually favourable stocks are not necessarily cheap
• Trading volume of penny stocks is approaching the 2000 level
• A total loss must always be taken into account

Penny stocks are stocks that are traded at a price of less than one euro or for a few cents. This magical price threshold of less than one euro is in the USA, in contrast to Europe, at five US dollars. Accordingly, all stocks with a market value of less than five US dollars are referred to as penny stocks in the USA. This somewhat different definition goes back to the regulations of the major US stock exchanges, which stipulate a minimum price of five US dollars for a listing.

The psychological effect of penny stocks

The main reason for the great popularity of stocks that cost less than one euro or less than five US dollars can primarily be explained by a psychological effect. The extremely cheap price suggests, especially to inexperienced investors, that the respective share is particularly inexpensive and thus offers high price increases. Because in order to achieve a return of 200 percent, a penny stock, for example, “only” has to increase from 20 cents to 60 cents, while a blue chip has to climb from 50 to 150 euros.
The probability that a share will rise from 20 to 60 cents seems to many investors to be significantly higher than the possibility that a share will rise from 50 to 150 euros. However, the percentage gain is the same in both cases.

However, this psychological effect is also often exploited by larger corporations, which optically cheaper their own shares with the help of a stock split. For many private investors, a share with a price of 25 euros is much more attractive than a share that costs 400 euros, for example. In this context, however, many investors seem to ignore the fact that the price of a share has nothing to do with the value of a company.

Not every penny stick is a “pig in a poke”

A share that is trading at around one euro does not necessarily have to be a speculative penny stock. In countries like Australia, Hong Kong and Great Britain it is even more the rule than the exception that some stocks have very low market values. For example, the shares of the British telecommunications group Vodafone are “only” quoted at around 1.50 euros, although the company, with a market capitalisation of over 40 billion euros, is one of the largest mobile communications companies in the world.
A very similar constellation can be seen at the Australian aluminum producer Alumina . Despite a solid valuation and a market capitalisation of around 3 billion euros, the Group’s share is only quoted at around 1.10 euros per share.
Accordingly, investors who want to distinguish a blue chip from a penny stock should not only take into account the price of the respective share, but above all also the total market capitalisation. Because classic Penny stock companies are often only a few million and not billions.

Gambling papers keep Wall Street busy

New trading platforms and apps, which are becoming increasingly popular in the USA, are currently ensuring that more and more, mainly young private investors, are trying their luck on the stock market. It so happens that six companies alone, each trading at around one US dollar, sometimes accounted for almost a fifth of the total US trade volume.
These penny stocks include companies such as Zomedica and Sundial Growers . While Zomedica produces various medicines for animals, Sundial Growers is a Canadian pharmaceutical company that produces various types of cannabis.

The bigger fool theory

Speculators who buy and push individual pennystocks with the help of social media such as Reddit usually follow the so-called greater fool theory. This theory describes an investment strategy that assumes that a share can be bought well above its fair value, as there is certainly another investor who buys the paper at an even higher price. This buyer is then referred to as a greater fool, as he pays an even higher price for the completely overvalued stock.

Small market capitalisation can be a problem

“Probably one of the biggest risks [speculators] face is the size of businesses in general,” continued Shipe. Since the market capitalisation of Penny stock companies is usually very manageable, they offer less protection for investors than standard values. Difficulties can arise very quickly when selling, as smaller companies often only have a low trading volume.
In social media, chat rooms and forums, individual users can use positive news and publications to ensure that the trading volume and interest in a particular stock increase, but such an influence borders on price manipulation.

Beware of pump and dump!

Penny stocks in particular are therefore very susceptible to so-called pump-and-dump systems. The classic pump-and-dump (inflation and discharge) is a scam that primarily aims to exclude smaller private investors.
For this purpose, various reports on smaller companies are published and distributed, often by dubious stock market letters or dubious stock market gurus, which are intended to encourage the purchase of the respective penny stocks with freely invented price targets. However, behind the often very elaborate purchase recommendations, mentions and press releases are fraudulent organisations or individuals who have already bought the respective shares before the first major publication or recommendation and are therefore just waiting for it. get rid of them with a hefty premium. In Germany, such a method is also known as a scalping strategy.

Pennystock – more of a betting slip than a share

Investors who are determined to invest their money in penny stocks should definitely keep the enormous risks in mind. With penny stocks in particular, it is more the rule than the exception that the investment ends in a total loss in the long term.
“Just make sure you can afford to lose and have rules about how to speculate,” Cole Financial Planning’s Scott Cole said in a Bloomberg interview. Basically, of course, nothing speaks against manageable investments in the field of penny stocks, but in this context one should speak of speculative bets rather than sensible investments. Pierre Bonnet / editors finanzen.net

This text is for informational purposes only and does not represent an investment recommendation.

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