There are a number of risks associated with trading penny stocks. The risks associated with trading penny stocks are no different than the risks related to trading a large cap stock, however there are a few special considerations. Let’s look at the general risks associated with playing the stock market and the special considerations that you should take into account for penny stocks.
Risk is the chance that the return on an investment will be different than what is expected. The main risk associated with trading stocks generally is market risk and it is very simply the potential for an investor to lose money to due to changes in the market. You cannot get around this risk. It is sometimes fickle and it is the nature of the system, which is why market risk is also called systematic risk. The market is affected by interest rates, natural disasters, wars, and political changes. The entire market is affected by these items and an investor cannot easily diversify against this (although, Nasim Taleb developed an investment strategy that focuses on the fact that we are prone to think that the future will be just like the past, and bets that things will be different).
The other broad risk related to trading stocks is unsystematic risk. This is the risk that a specific company or industry will lose value. One of the most important ideas in finance is that there is a relationship between risk and return. The greater amount of risk that a person is willing to take on means that there is a greater potential return on the investment. Trading penny stocks has a higher risk associated with it so there is a greater potential for return.
Penny stocks have a high event risk, which is the risk of loss due to the actions of or related to a company. The event risk is high because the information available to an investor is limited. Many companies choose not disclose very much and they are not held to the same standards as a company trading on the New York Stock Exchange.
Investors in penny stocks also need to consider the liquidity risk associated with these investments. If a stock becomes unsellable, it cannot be bought or sold quickly enough to prevent a loss. With penny stocks, large price swings are common and this means high liquidity risk. You buy the stock but suddenly find that you can’t get out of your position.
If the risks are so high, why are penny stocks so popular? Penny stocks are popular because they are also high return investments. There is absolutely no guarantee that you will get a high return, in fact, it is far more likely that you will lose it all, but it goes back to the principle that risk and reward are related. You are taking on significant risk when you begin trading penny stocks and therefore there is the potential for a great reward. To make money at all, you must take on risk. There are no high return investments that are low risk. Trading penny stocks isn’t for those with a low risk tolerance, but if you are willing to risk losing most or all of your investment, trading penny stocks is right for you.
As an alternative, consider creating a risk adjusted portfolio through MarketRiders or Wealthfront. These companies allow ordinary investors to create professional grade investment portfolios for a fraction of the cost. You are more likely to have higher returns over your lifetime by adopting a long-term outlook and rebalancing your portfolio based on your investment strategy. Penny Stocks are inherently risky due to their lack of liquidity and the excessive misinformation that is produced by paid advertisers. The better strategy is to create a risk adjusted portfolio using a low-cost methodology (think ETF).