As the famous investor and hedge fund manager Peter Lynch used to say – “you get recessions, you have stock market declines. If you don’t understand that’s going to happen, then you’re not ready, you won’t do well in the markets”. You need to be sure to minimize the impact of bear markets and high market volatility.
Having a well-diversified portfolio is one way to temper potential losses. But what does it really mean to have a diversified portfolio? First, you need to invest in different asset classes, which are not positively correlated, so then you can mitigate unsystematic risk. Then, you also need to use diversification within a specific asset class.
Let’s take the stock market as an example.
If you want to have a diversified stock portfolio, you can focus on different sectors with strong and promising growth prospects and high potential returns, regardless of the market and business cycles. You can also focus on different kinds of stocks, as there are many different kinds available. You can invest in value stocks, which refer to stable and mature stocks that are trading below their intrinsic value, or in growth stocks, which describe fast growing companies with substantial revenues and earnings prospects. You can also focus on big, well-known, and stable multinationals, or you can focus on smaller, more volatile, and less mature companies like penny stocks.
Penny stocks, also called microcap stocks, represent companies with small market capitalizations whose stock price is usually under $5 per share. Most penny stocks are quoted over-the-counter, which means that they are not really supervised by large stock exchanges like the NYSE, meaning that they do not have to comply with strict listing requirements. These stocks attract an increasing number of traders and investors with limited trading capital looking for a cheap way to get into the stock market. But they also attract big players like corporate insiders, hedge funds, as well as investor relations firms.
There are different reasons why these market participants (and many others) want to buy penny stocks.
First, penny stocks could become tomorrow’s big success. After all, some of today’s most important and stable companies, such as Apple, Ford Motor Company, Alphabet, and Monster Beverage Corp, started as penny stocks. Such an investment in the early stages of a company could provide early investors with massive gains over time.
Secondly, penny stocks are quite volatile assets, which can be great for speculators, short-sellers, as well as experienced penny stocks traders ready to take advantage of price fluctuations. While this volatility can be risky for beginners and unwary investors, it is a great tool for aggressive traders that want to make money quickly with a small initial amount invested.
So, should you add inexpensive stocks like penny stocks to your investment portfolio? Perhaps – it all depends on your investment strategy, your risk-tolerance, and your financial goals. In any case, you shouldn’t start investing in penny stocks before you fully understand what penny stocks are and have a sound trading plan with clear and achievable goals