Why Penny Stocks are never a Good Idea
When I was younger and first started learning about the stock market I was a bright eyed 13 year old that would have believed anything you would have told me, because, of course, adults knew everything at the time. That being said, now that I am an adult, I don’t think I’m any smarter. But when I was this bright eyed kid, I grew an obsession with the world of penny stocks and day trading. It’s just so appealing. Make 200% on your portfolio in a day, never lose, the next big thing – all sounds bites that I heard, and still hear on a daily basis, because that is the sound bite that sells your typical investor. Well, I got into that area and did extremely well on every practice account that I ran, though, for some reason I wasn’t able to match my returns once I moved over the real market, and here’s why I wasn’t able to, and why no one is able to do that.
- Penny Stocks are extremely volatile
Penny stocks are classified as any stock with a closing price of less than $5.
I went ahead and threw that parameter into our screener and you can see that the overall standard deviation of this strategy is 12.3% – three times that of the overall market, and penny stocks lose an average of 2% annually as a group.
- There’s no Liquidity
There were 196 matches for companies with a close of less than $5. We typically keep the incredibly sketchy OTC companies out of our software, but for this example I needed everything we had.
I went ahead and added the parameter that every company needs to have a consistent dollar amount traded each day, and that each company needs to have had that trading volume daily since going public. Well, our list just got cut into tiny little pieces as only 4 companies pass that single parameter. If you invested in the other 192, you may have been filled and then run into the problem that every time you try to liquidate that position the price of the entire company moves downward, killing your returns.
That being said, your returns are already in the garbage as you are still losing money in an extremely high risk portfolio.
- You Can’t Trade them in Long Term Strategies
I personally don’t like looking and trading within my portfolio every day. It may be that I go to University and work, or it may be that I would rather not deal with commissions and slippage. Or it could be both…It’s both. Let’s delve into this deeper. If you change our overly basic penny stock strategy to trade on a weekly basis, so we still aren’t looking at our portfolio every day we get these results.
Not good results, but better than before, at least now we are beating the S&P. Sadly though, this strategy doesn’t include trading costs, and we took on over 1000 positions during this time period, and since we are trading small cap, penny stocks we are going to experience higher trading costs, whether it’s higher commissions or more slippage, so I’m going to add a trading cost of 1%
If we do that we get a backtest result that rhymes exactly with what we had before, just, this time the results are far lower, only making an average of 1% annually compared to the 4.3% we made before. All in all, there aren’t really any redeeming factors for investing in penny stocks unless you would rather gamble than invest, and in that case, go to Vegas… It’s less stressful than the markets.