The following is a contributed article from a content partner of Benzinga
Investing for your retirement is a lifelong journey that should be started as early as possible.
Many young investors are attracted to penny stocks because they see them as a cheap way to accumulate a large position. Buying 1,000 shares of a stock at $1 is feasible and seems a lot more attractive (at least on paper) when compared to buying nine shares of Apple or a fraction of one share of Amazon.
Stocks that trade under $5 per share can play a role in your retirement portfolio, so long as you follow a few basic tips that emphasize investing responsibly.
Tip 1: Understand Why A Penny Stock Is Cheap
A cautionary tell on penny stock investing is warranted. Typically, a penny stock trades at such a low price because the demand for the stock is low. Many penny stocks are mostly unproven companies with little to no track record.
Other penny stocks thrive off of fraudulent schemes. Brokerage firm Bank of America Merrill Lynch banned its clients from trading certain stocks priced below $5 per share.
Sometimes, penny stocks include large and recognizable companies that just fail with the times. One of the most notable examples in recent years include car rental company Hertz that even attracted an investment from billionaire investing guru Carl Icahn.
Hertz was among the most impacted companies from the global COVID-19 pandemic. Demand for its car rentals collapsed nearly overnight and Hertz, a company already bleeding cash pre-pandemic, was dealt a fatal blow.
The stock collapsed to penny stock territory because no investor wanted long-term exposure to the stock. As a side note, a pending bankruptcy didnâ€™t stop a bunch of penny stock traders from bidding up Hertzâ€™s shares by 900%. They even ignored the companyâ€™s own admission itâ€™s demise is all but certain.
Hopefully, long-term investors werenâ€™t convinced Hertz can recover from a global shutdown due to a pandemic with no end in sight.
Tip 2: Assume Reasonable Risk
New and young investors shouldn’t be faulted if they want to allocate 10% of their assets to penny stocks. The logic being that a mega return of 1,000% or more can advance your retirement dreams by years.
The downside scenario to the surprise of many is a profitable portfolio. Assume the responsible and disciplined investor allocates 90% towards index funds, like the S&P 500.
In fact, the S&P 500 index is up around 14% for 2020. This means that under an absolute worst-case scenario the penny stock portion of a portfolio collapses to zero, the investor is still positive for the year. Hard to believe? The math as part of a $5,000 portfolio is quite easy to follow:
Penny stocks: 10% of $5,000 = $500 investment.
Index fund: 90% of $5,000 = $4,500 investment.
The value of the index fund portion, assuming a 14% gain would be worth $5,130. So, at the end of the year, the investor still made money even if the penny stock experiment was a complete failure.
Tip 3: Recognize Exceptional Returns Exist, But It Is Far From The Norm
How much money can an investor theoretically make in penny stocks? As has been the case in 2020, the answer is simple: a lot. Potentially even life changing.
E-Commerce company Overstock.com is one of a select few stocks that skyrocketed in 2020. Shares traded as low as $2.53 at the peak of the COVID-induced selloff in March but momentum sent shares skyrocketing as high as $128.50.
The same $500 investment from our prior example could have bought around 200 shares at the lows. But let’s assume that just 100 shares were bought at $500. If the stock was held all the way to $100 a share the position would be worth $10,000.
Late-stage biotechnology company Novavax develops vaccines for serious infectious diseases. The stock traded as low as $3.65 in early 2020 and by summer time it was pushing the $200 per share level before losing momentum.
Are these types of return the norm? No, of course not. To suggest investors can pick any penny stock at random and realize these levels of returns would be foolish. Even a fraction of these gains is unrealistic.
But much like a lotto pick, someone eventually wins big.
So what is a realistic return for penny stocks? According to a 2016 SEC white paper titled â€œOutcomes of Investing in OTC Stocks,â€ a sample of more than 10,000 OTC stocks from 2001 through 2010 found an average annual return of negative 27% and a median annual return of negative 37%.
Tip 4: Donâ€™t Marry Your Penny Stock
One of the most important traits an investor needs to demonstrate is agility and flexibility. If you buy a penny stock with the intention of holding it for months or even longer be prepared to change your timeframe.
While there is never any way to know if your penny stock will continue its charge higher or completely lose all momentum and give up gains.
If a penny stock is up 50% it would be reasonable to sell 75% of the position and closely follow the remaining 25%. If the momentum continues then all the better. But if a reversal starts to form, it would be wise to exit the position and move on.
More often than not, a penny stock investor watches a large gain very quickly turn into a small gain or even a loss. Consistently banking â€œsingles and doublesâ€ over the decades is a much more reasonable strategy than consistently â€œswinging for the fences.â€
Source: Google Finance. Vaxart Inc: From pennies to a 52-week high of $17.49 then back down to $7.
Conclusion: Be Careful
Penny stocks can safely account for a portion of your portfolio, so long as the majority of funds are invested responsibly. Investors need to always keep in mind that investing in penny stocks has much larger risks than established blue chips so it is best to keep expectations low.
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