Derek, I heard about a great penny stock, should I invest?
The allure of getting rich in the stock market can be a very powerful incentive to invest in a small company that you may not fully understand. To be sure, there are two ways to put your hard earned savings to work – one is to invest, and the other is to speculate. If you invest, your plan typically is to earn a consistent return over the long-term. If you speculate, you’re hoping to make it rich in a very short time frame. In my experience, those who speculate tend to lose a lot of money.
Too often an investor brings a penny stock to my attention with the hope of making lots of money. The scenario typically plays out like this: they have a friend or co-worker who knows someone who works at the company they are wishing to invest in. Usually, the story is that the company may be on the brink of a huge contract, a big resource discovery, or an amazing cure for a disease. Whatever the background, the potential for return seems astronomical. The reality tends to be the opposite.
My experience tells me that most of these ventures fail miserably. I have seen hundreds of thousands squandered on these ideas. While it can be true that a very small percentage of these companies may ultimately succeed and the rumours turn out to be true; it is more likely they are simply that, rumours.
Before investing in a small company that trades for pennies a share, it may be helpful to decide how much you’re comfortable losing. In fact, you should be perfectly comfortable losing all your investment. There is no magic number; it is simply a decision that if that money were to be gone tomorrow, it wouldn’t change your financial circumstances.
Be aware that investing in a penny stock isn’t just a high risk venture; it’s beyond that – it’s speculative and you have a real chance of losing money. Once you’re comfortable with how much money you’re willing to lose, you can move on.
The next step should be to understand why there is so much hype about this company in particular. Too often these opportunities follow the pattern of what is known as a “pump and dump” scheme. This is where a major shareholder spreads false rumours about the company in efforts to drive the share price higher.
In these cases, the share price moves higher (pump), the major shareholder sells their shares at this lofty price (dump), and the shares come crashing back down.
The hopeful investors are left holding worthless shares while the major shareholder walks away with a hefty return.
Another consideration is to be aware of how many shares trade on a daily basis. With penny stocks, you will often see a few thousand shares traded daily or perhaps none at all.
This is important because you need to be aware of how easy it may be to buy the shares at a fair price and get your money back at a fair price.
This is referred to as the “bid-ask spread”. In some cases you may have to buy the shares for notably higher than what the actual value is.
Furthermore, if there are no buyers, this makes it especially difficult to get your money back if you wish to sell.
The final thought is to determine why you’re investing in the first place. In most cases, investors who save money regularly do not need to make giant returns to meet their goal.
While it would be nice to make millions in a hot stock, the reality is that most of these ideas will set you back further in the long-run. I often say to keep your life exciting, and your investments boring.
Boring investments may not make you rich over night, but they shouldn’t lose all your money either.
Lastly, before you make any investment decisions, it is critical that you discuss your objectives and tolerance for risk with a professional advisor. They should help provide clarity to your long-term goals and return requirements. As the old adage goes, slow and steady wins the race.
Happy investing!
Wealth Watch is written by Derek Fuchs, a wealth advisor with ScotiaMcLeod in Red Deer. It is provided for informational purposes only and any opinions contained in it are his own. Readers are urged to consult a wealth advisor for help with their personal investment circumstances. Fuchs can be contacted at derek.fuchs@scotiamcleod.com.