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The question of stocks vs penny stocks, (aka low-capitalization stocks, or OTC Stocks), is one that enters almost every investors mind at one point or another. It’s an interesting question to consider too, as there are quite large differences between the stocks that most people see listed on the major indices and the penny stocks that are only traded over-the-counter (OTC). And you likely won’t be surprised to learn that many of these differences rotate around the concept of risk.
Of course, before we begin any discussion of stocks vs OTC stocks it’s important to have a definition of each so we can understand exactly what it is that we’re comparing. When we talk about “stocks” we are usually referring to publicly traded companies that have been listed on major exchanges like the New York Stock Exchange. These are often, but not always, well-known names and larger, more stable companies. Investors often prefer this type of stock because it can be considered a “stable” investment that will provide a long-term growth horizon.
The very best of the regular stocks give an investor the combination of a relatively inexpensive price based on the company earnings, a solid and rising dividend, and good growth prospects. In general, the best regular stocks share these common traits:
- They are stocks of successful companies
- They have a dividend that’s been increasing regularly
- They have good cash flow, strong management, and prospects for growth
These are the stocks that a long-term portfolio is built around.
Penny stocks typically do not display any of these characteristics. Instead they offer to South African traders a potentially large gain in a short period of time. Unfortunately, this chance to score a big gain also comes with increased risks, and it is far more likely that a trader will be disappointed by the performance of the OTC stocks they invest in as most remain relatively unchanged, and some even drop significantly from their already low valuations. Penny stocks are inherently riskier and often engaged in risky behaviour in order to get a hook in their industry. Investors need to be extra careful about the low-capitalization stocks they choose to speculate on, lest they end up losing a pile of money rather than making a pile of money.
Speculation in Stocks vs Penny Stocks in South Africa
Investing in regular listed stocks is rarely considered speculation. Instead it is called investing. Speculation typically involves much greater risks, and potentially much greater rewards, while investing expects a steady and stable increase in the value of an asset. Of course, there are merits to both, depending on the goals of the trader. And it’s possible to invest in regular stocks while also speculating in smaller penny stocks.
When it comes to making money there are times when an investment in a regular stock ends up turning into a loss. Choosing a company’s stock at the wrong time could lead to losses if the stock struggles due to poor management, a challenging business environment, or a number of other factors. However, in the long run these stocks can and often do recover. And in the meantime, many of them also provide the investor with a steady cash-flow in the form of dividends.
With penny stocks it is far more likely that you will lose money, and that the stock will never recover. It is also more difficult to choose a good OTC stock to invest in because often the only reason the stocks end up soaring higher is strictly down to luck. Recently Elon Musk’s tweet sent penny stock soaring, but company insiders didn’t sell shares. The problem is that for every penny stock where a trader gets lucky there could be three or five or even ten where he doesn’t get lucky. These others can simply end up as a wash as the stock doesn’t move much, or they can end up as a massive loss.
That’s why investors often mix regular stable stocks with a small allocation of OTC stocks that increase the speculative and aggressive portion of their portfolio.
It’s important to understand that the risk of loss with a penny stock is much greater than the chance of success. If you plan on speculating on low-capitalization stocks there should be a very strong reason to buy the stock. Some information that could lift the stock in the future or some change at the company that could make the shares more attractive.
The worst course to take with penny stocks is simply buying them on a hunch or a whim. This is typically no better than going to a casino and spinning a roulette wheel. You might win once or even several times, but eventually the house is going to win and empty your pockets.
Penny Stocks Prospects are often Exaggerated
A large company with a household name has little reason to launch a marketing campaign to make themselves look better than they are to investors. They already have plenty of people willing to invest in their stock.
Low-capitalization stocks are quite different. Oftentimes the promoters of these small issues will make a deal, however tenuous, with a major company as a way to boost the reputation of the penny stock company. Any link to a major corporation is seen as a sign of trust, and it can lead to more investors willing to purchase the penny stock.
The problem is that in many cases when some deal or cooperation between a major company and a penny stock company is announced it is overblown and made to look much bigger than it actually is. In many cases when such a deal is announced it is often a good time to sell the stock on the resulting rally because once investors realize that the deal isn’t so big as promoted the stock will soon sink back to prior levels.
This can also happen with regular stocks when they announce a new technological development, partnership, or product, but typically there is no exaggeration of the deal and any resulting rally will typically stick.
Penny stocks can be scams
Because they have a smaller number of outstanding shares and are typically quite illiquid, shares of penny stocks are far more likely to become the target of manipulation. Some of these stocks are even launched with the intent to create some sort of scam that lures investors in, makes the founders rich, and then the stock falls into oblivion. Investment fraud is well known to be more common with penny stocks, where the low trading levels make them easy to manipulate.
Penny Stocks are for Speculation
Buying the right penny stock at the right time can lead to a huge windfall, but the odds of seeing returns in the hundreds or even thousands of percent are diminishingly small. OTC stocks are inevitable far riskier when compared with regular stocks. Often penny stocks are involved in some venture that is unlikely, such as development of a new medicine or technology, or searching for oil or mineral deposits. This makes the stocks more of a gamble since there’s a component of luck involved in the performance of the underlying company. Of course, some luck is also involved when large, established companies are considered, but this luck is a far smaller component in the overall performance of the stock.
Penny stocks also suffer from being far less liquid than regular stocks. Because of this you might find that it’s impossible to sell a penny stock when you want to. You can also see much greater volatility in the price of penny stocks as any small news can cause a penny stock to rise or fall dramatically. More liquid regular stocks have greater price stability, and it is unlikely you won’t be able to find a buyer when you’re ready to sell.
Whenever you do choose to speculate on penny stocks a good rule of thumb is to take some profits whenever the stock rises. Ultimately if you can recoup your initial investment then any stocks you still own are essentially “free”. Of course, the same strategy can also work with regular stocks, but typically it isn’t as necessary since the larger stocks that trade on the regular stock exchanges are far less volatile.
Here’s AvaTrade’s South Africa personal selection of top Stocks to trade.
Ultimately these larger stocks should make up the bulk of any traders’ holdings, with the smaller and more volatile penny stocks relegated to a small portion of the diversified portfolio. Because penny stocks are so speculative, they should only be purchased with money that you can afford to lose.
When choosing between regular stocks and penny stocks it is crucial to remember that regular stocks of well-known companies are for investing, and they should make up the bulk of any portfolio. OTC stocks are speculative, and should be handled as such, with them making up just a small portion of any portfolio.
Regular stocks will hopefully provide steady and stable growth in the long term. Penny stocks are for making quick profits in the short term. Both have a place in any portfolio, but the risk factor in penny stocks needs to be remembered.