Sharing Some Lessons LearnedMost penny stocks, for various reasons, are never going to go anywhere. Reason range from opportunities that will never materialize, lack of management skills, inability to raise sufficient capital, poor regulations and share price manipulation, among other pure business risks.
Still, there are opportunities to make money but you have to make sure the company has a good opportunity, is well financed, and has a reputable management team. If you can’t find reliable information on a company, simply move on.
There are certain situations you want to avoid.
First off, you want to avoid early stage companies with an unreasonably high number of issued shares and a large accumulated deficit because that indicates failures of past transactions. It is also a sign of promotion activities by management where their primary business is to raise capital that is destined for their own pockets
Another thing to avoid is companies with thinly traded stocks. Thinly traded stocks have low daily and monthly trading volumes. The problem with these is that when you want to get out quickly, you may only be able to do so by significantly lowering the ask price to attract a buyer.
Never believe in stock tips or what anyone says and independently verify every claim made. This is especially important on internet forums. Everyone has their own self serving agenda and no one except you has your best interests in mind. So be thorough in your due diligence and do not rush into any investment out of fear it will move up without you. Remember there is always some money to be made in a good investment.
Reliable information can be found via SEDAR, SEDI, the exchange sites such as the TSX, CSE, TMX among other sources. If you do not know what these are, you have no business investing.
You also want to know exactly why you believe the stock is going to move up from where it is now and what might trigger these increases. Here Google may be your best friend. Research the opportunity, what success looks like, what it takes to get there, who the competition is and whatever you can find.
There are also some good rules to adhere to when investing in stocks, especially penny stocks. Note there are always exceptions to every rule, but know exactly why you are breaking it and your reasoning should never add to your risk.
For example, you might set your exit price and retain all or part of your position. As long as that reason is not greed related but based on some fundamental aspect of the business, you could reset your target return.
Rule #1
Never invest more than you can lose
Penny stocks should not account for more than 10% of your total equity portfolio on a fair market value basis. You might accept temporary deviations from this, but not for any length of time. Shift money back into your blue chips or cash to reduce your exposure to risk.
Rule #2
Do not invest in more than 3-5 risky stocks at a time
You need to keep a close eye on these investments, so you definitely do not want to have to monitor more than you can handle. I have always found that 3 is a good number, but I can handle an extra 2 without a lot of extra effort if a good opportunity presents itself.
It’s important to note that diversification does not apply here because you are actually making a bet on a particular stock so trying to spread risk is is not the way to reduce risk. Only solid research and managing your exposure can do that.
Rule #3
Keep a close eye on these investments
I track my penny stocks using Globe Investor and a spreadsheet and I update the closing stock prices daily. This allows me to quickly see my gain and loss position and lets me decide what action I might take the next day. If the stock moves up or down, it may be time to exit partially or entirely. I also set and record a target exit price when I buy so I can quickly see how I am doing in relation to that.
Rule #4
Do not be afraid to take gains or realize losses.
Do not get greedy. Penny stocks often rise quickly and fall back, even when everything else about the company is good. That means you should trim your position when you can take a reasonable profit and sell completely when you achieve your target. You can always buy back in on a pullback if it happens.
Conversely, get out at a pre-determined acceptable loss and learn from your mistake. Far too often the pull back is significant because people are bailing. Do not make the mistake of thinking it will turn around again because it may not and most likely will take longer than you think. It is simply good management to limit your loss to an amount acceptable to you and not an amount that is determined by the market. Accepting a loss is difficult. This has been proven by psychologists. But it is simply imprudent to lose more money because you did not sell when you should have.
Note this also means you should not try to make your money back by averaging down. The risk in penny stocks is too great. Now never say never, there may be a situation where you make an exception, but it should be exactly that. An exception. And it better be based on sound investment principles and not on thinking you will break even faster. Again, pull backs are common, go deeper than you think, and take longer to recover than you think. Worse, while you wait for the recovery, you have “dead money” in the market waiting to resurrect. Do not make the mistake of thinking “it will be different this time” because it very rarely is
In applying this rule, and setting your acceptable level of loss, think risk-reward
Consider a 50 cent stock that you want to see go to $1 a share. If you decide to sell if it drops to 40 cents, then your acceptable downside is 20% and desired upside is 100%. Another way to say this is you are willing to risk 20% to make 100%, a 5:1 ratio. If you say you are prepared to sell at 30 cents, you are willing to risk 40% to make 100%, a 2.5:1 ratio. To me that is not a good enough reward for the risk assumed.
Rule #5
Do not let emotion get in the way of the numbers
Greed is an emotion. Fear of loss or missing out is an emotion. Regret is an emotion. Over confidence is an emotion. Falling in love with a story is based in emotion.
Every company has a great story about how they’re going to make money, or better yet, about how they will disrupt their market or change the world. As true as it may end up being, that is an emotional aspect that should take a back seat to the numbers you set as your investment parameters.
Now this is easier said than done because we are emotional creatures. The best way to overcome emotion is to accept you are human and to stick to the fundamentals. Base your purchases on sound research and make decisions based on your targeted numbers and financial constraints. Try and remember that everything else is simply noise.
Rule #6
Keep learning about investing and learn from every trade you make
Win or lose, it makes sense to try and understand why you gained or lost money.
If you won, what happened that caused the price to increase? Should you have gotten out much sooner with 80% of the win because the final 20% took far longer to achieve? If so, what were the signs? This is but one of the many questions you should learn to ask
If you lost, why? What did you miss or neglect to do?
Read relevant books, magazines and newspaper sections and keep adding to your learning because wisdom is knowing what questions to ask. Every piece of information you gather makes you a stronger, wiser and more profitable investor, and that should be your overall goal
In summary, these 6 rules are really about managing the risk associated with investing, and in investing in small cap stocks in particular. Seasoned investors know you can never eliminate all risk, you can only ensure you are willing to accept the risks associated with an investment.
This means setting and adhering to some basic rules, and finding out all you can about your investment. Why is it a good opportunity, why and how will it increase in value, and when will you sell are the key three questions to answer. Do this in a disciplined way and you will effectively manage your investment risk.