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Coping with the risks of investing in penny stocks

by , 01 September 2015

Investing in penny stocks can be extremely profitable. But with the possibility of great gains comes risk.

To invest in penny stocks you have to comfortable with the risks you take on. If you want the potential of making money on these shares, you have to accept that you may lose money along the way.

Let's take a closer look at the risk side of penny stocks and how to manage it…

The risks of investing in penny stocks

Penny stocks are the riskiest shares on the stock market, and reflect the relationship between risk and returns. The bigger the potential risk, the bigger the potential return.

As the Credit Suisse Yearbook for 2015 points out, penny stocks have been the top performing investment class for the past few decades. They founds that the returns from penny stocks beat large-cap stocks, gold, alternative assets, bonds and hedge funds.

To invest in penny stocks, you have to accept the greater risks that come with them.

How penny stocks differ from large companies

To manage the risks of investing in penny stocks, you need to understand how they differ from other shares, Sean Keyes in Penny Sleuth explains.

Firstly, penny stocks are more volatile than shares of large companies. This means you need to accept that the price of penny stocks can move about a lot. Try not to let this volatility stress you out.

Secondly, penny stocks have the potential to grow at breakneck speed compared to large companies. A penny stock has the potential to soar in value over a very short period of time.

How to manage your risks investing in penny stocks

Due to the volatile nature of penny stocks, stop losses aren’t always the best option. The price of a penny stock can plunge only to recover, but trigger your stop loss in the process.

Instead, you should spread your capital across a large number of penny stocks. Only a handful of the penny stocks you invest in will become real winners.

By limiting how much you invest in each, you limit how much you can lose on each pick. By spreading your investment capital across many penny stocks, you increase the chance of finding the best ones.

When investing in penny stocks, invest a smaller amount than what you would in another share. A good rule of thumb is 3% of your total portfolio.

So there you have it. How to cope with the risks of investing in penny stocks.

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Coping with the risks of investing in penny stocks
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