Why “Real” Investors Avoid Penny Stocks

There has always been a lot of controversy surrounding the world of penny stocks. Something about companies with share prices of a few cents or less can scare away diligent investors. After all, if any of these companies were so great, why wouldn’t they be valued higher? The fact remains that a majority of penny stocks are complete junk. These companies are infamous for their sketchy management teams, lack of revenues, “fluff” press releases, and paid promotion schemes. I am not here to discuss the credibility of penny stock companies because that is irrelevant to my point. Instead, I am focused on dispelling the myth that you cannot make money from penny stocks. A lot of “real” investors consider penny stock trading to be a gamble with very low statistical odds of winning. These investors scoff at the naivete of anyone trying to make money in the penny stock market. In reality, these investors are just as naive as those they scoff at. I am not here to refute statistical claims or any other fancy industry jargon because none of that is relevant to my point. I believe that the main reason most “real” investors fail at trading penny stocks is that they fail to understand the market environment.

Awhile back, on a trip to California, I was engaged in a casual poker game with friends. We were playing for money, however, the game was intended more for fun than it was for profit. Mid-way through the first round of poker, I found out that one of the people I was playing with was actually a professional poker player who played in tournaments on a regular basis. After discovering this, I instantly assumed that no one else at the table had any chances of winning. I mean, how could anyone else win when we were all in the presence of an experienced professional? As the game progressed, I was shocked to discover that the professional player was not doing any better than anyone else at the table. In fact, he was losing a lot of money to people who had only played poker a few times in their lives. Eventually, someone made a remark to this professional player and proceeded to ask why he wasn’t dominating the table. The professional poker player replied that playing poker is different when you are playing with newbies because they don’t follow the same patterns that professional players do. Simply put, these newbie players are unpredictable. So there I was at a table where a professional who had been playing poker for years had no edge over people who had only played a few times. This professional’s skills didn’t matter, nor did his experience, composure, tact, or anything else that would have helped him at a professional table. His skills were rendered useless because he was in an unknown environment. Hopefully, by now, you are catching on to the comparison I am trying to facilitate through this anecdote. Professional traders fail in penny stock markets because they do not understand who they are trading with. Their skills don’t matter, their technical analysis is futile, and their fundamental due diligence is irrelevant.

When you enter the world of penny stocks, you are no longer trading with professional investors, hedge fund managers, and other accredited individuals from the financial world. You are trading with newbies, gamblers, chartists, flippers, market makers, and dreamers. Of course, there are also a few professionals, but they are rare. So, what does all of this mean? Let’s resort back to the poker analogy. Who would have the best edge at the table discussed above? Was it the professional? Certainly not. His skills/experience may have been enough to prevent huge losses, but his advantage was minimal at best. Was it the newbie? Maybe, but that would just be luck, and not necessarily replicable. So, who was it? At this particular table, no one had an edge, and, most often (just like in penny stock trading) this is how it will be. However, if someone came to the table and understood the psychology behind how each person was playing, they would certainly have an advantage. Understanding all of the elements in your environment is crucial for success. In penny stock trading, those that understand the psychology of the market will have the most success.

While penny stock trading may not follow the same patterns as large cap and small cap trading, it definitely does follow some patterns. Keep in mind that most trades are executed by people, and these people have a certain thought pattern that drove them to make that trade. By carefully observing and analyzing the psychology of penny stock traders, you can begin to discover patterns that give you an advantage over other traders. Ask questions. What motivates people to buy? What motivates people to sell? What triggers a breakout? How will a press release affect price movement? Are people trying to make a quick buck flipping shares or are they holding long? In no way is this a simple analysis and in no way is it fool proof. However, with time, you can pick up on patterns that will contribute to your strategy.

If “real” investors want to find success in the penny stock market, they need to forget everything they know and be prepared to develop a new strategy. Every single day, different penny stocks skyrocket by a few hundred percent, sometimes even over a thousand percent. Someone is making money off of that. In fact, that is a huge appeal of the penny stock market; you can make huge percentage gains that are unimaginable for large cap stocks. To say that you can’t make money from penny stocks would be naive. While investors with multimillion dollar portfolios may be happy making 10-20% gains each year, these gains won’t do much for someone with a small portfolio. If you have a small portfolio and want to actively trade your way to high gains, than penny stock trading can be a viable option.

I’m an investor and business owner with a strong focus on fundamental analysis. When I first started trading penny stocks, I wouldn’t touch any stock that didn’t have solid fundamentals. Every single day, I would see different companies’ share prices skyrocket; companies with shady management, no revenues, and sketchy paid promotion schemes. Nonetheless, I wouldn’t touch them. I thought of this movement as random, and didn’t want to get involved in this nonstrategic nonsense. I was using a value based investing strategy in a market that ignored this kind of reasoning. My preconceptions were hindering my success. Eventually, I took the time to learn what was causing this kind of movement. These movements could be caused by catalysts such as press releases, pump and dump schemes, paid promotion, technical analysts playing the stocks on their screeners, etc. I began to discover which catalysts would move a stock, keeping in mind the whole time that these catalysts changed people’s “perception” of the stock, and not the the company itself. In the penny stock world, the share price is the product, and companies work diligently to move the price up. Fundamentals have their place, but are not given as much weight as they are in other markets.

I could talk about technical analysis, fundamental analysis, and different catalysts for days, but that is not the point of this particular post. The point is simple; learn about the psychology of the penny stock market environment and you will gain a competitive edge. Be prepared to incorporate your insights into your strategy. Whether you are going long or short, holding for days or minutes, or utilizing a completely different strategy, make sure to think about how other traders are thinking.