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Don't let penny stocks turn your fortune into a penny (1 of 2)

People love penny stocks. Why?
Because
a) Available at such low prices, as compared to the blue-chips, they look very attractive.
b) Low-prices can double much easily than high-prices

But this where that the problem starts. Investors forget one of the basic rules of investing – look for ‘value’ not ‘price’. 

It is true that penny stocks have the potential to give multiple returns vis-à-vis their expensive cousins. But going by the risk-reward ratio, the odds are heavily staked against the investor. Investing in penny stocks is more a cup of tea for a seasoned stock-market investor or someone with money to burn. Therefore, ideally speaking you should avoid investing in penny stocks. 

But still if you feel you have the stomach for it, it may be prudent to keep the following points in mind. While, these will not guarantee any success, they will at least improve your odds.  

1. Investing in low-priced stock does not mean easy money
Psychologically, it is comforting to buy a share of XYZ available at say Rs.15/share, than say Infosys at Rs.3000. Secondly, it is more likely for Rs.15 to become Rs.30 than Rs.3000 to become Rs.6000. And, thirdly with small amounts (say Rs.15,000) you can buy more shares of XYZ (1000) than Infosys (only 5). Therefore, low priced shares appear to be a surer way of making easy money.

However, people forget that if it looks easy to make 100% or even more profits in XYZ, it is equally easy to lose money. Rs.15 can easily become Rs.7.50 and you lose 50% of your investment. But it will be difficult for the Infosys to fall to Rs.1500 (and even it does, it will bounce back but penny stock won't). Historical evidence shows that there is much higher probability of losing money in a penny stock than in an established one. So why take more risks with penny stocks?

2. Lack of information
One of the basic problems for a penny stock is the lack of information... especially reliable information. Most of these companies do not have any track record to speak of nor are they in a business that enjoys good future potential. And more often than not, such companies are managed by promoters of dubious intentions. 

In the absence of credible & tangible information, it becomes difficult to make an informed judgement. Most of them are not tracked by any of the major investing firms. Therefore, in such a scenario, choosing a penny stock is like looking for needle in a haystack.

Penny stocks require a much more detailed research. What is the management’s track record? What is its’ core business? Is it making profit and are those profits genuine? Are there any questionable transactions say with the group companies? Has the company been penalized by any regulatory authority? Has the company undergone name change to keep pace with the changing times (e.g. from finance company to infotech to biotech)? 

Look for stocks that are ‘truly undervalued’. These situations do happen; but are of course difficult to spot. Only a seasoned day-to-day investor is in a position to detect them. With lakhs of investors, thousands of brokers and hundreds of analysts, whose daily bread & butter comes from stock markets, it is very difficult for a good scrip to remain penny stock for long time.

Read Part 2 of this blog post here... 'Don't let penny stocks turn your fortune into a penny - Part 2'.

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