Why Penny Stocks?

So why penny stocks?

The answer to this question should ultimately rest with the investor’s own tolerance for risk. It’s funny that after writing almost 50 blog posts on the subject, I would even feel the need to take the time to address this question, but for the beginning investor, they may need a little help in understanding my own reasoning for even fooling with penny stocks to begin with. The penny stock trader, in my mind, has a different “risk profile”, if you will, than the average stock trader or investor. There are a lot of people who come from the school of the Graham-Dodd style method of stock valuation, or even O’Neil’s CANSLIM method, and each of these systems have their merit, but at the end of the day, there’s no indicator or metric you can use to factor in human greed, fear, and emotionalism, which in my mind are the ULTIMATE drivers of stock prices. There has always been an “efficient market” theory floating out there, i.e., that stocks tend to trade at a “fair” value, and that there can really be no reliance on notions that a stock is “overvalued” or “undervalued”, but I find this to be complete and utter bullcrap. Now it’s true that value is ultimately determined by the price that is paid, but what determines prices? Human perception of value, which again can be skewed beyond belief. Remember the “dot-com” era? Is anyone who bought some Webvan stock happy about it right now?

Let me tell you, back in the late nineties, you could do no wrong if you bought a stock that had anything to do with the Internet. And everyone from the ratings agencies to the large brokerage houses that were pimping these stocks were convinced that they had real value, because they had all the ratios, accounting trickery, and in-depth analysis to prove it. But at the end of the day, in hindsight, the entire tech sector of the late 1990’s was a huge-anus bubble that was fueled by human greed, hysteria, and fantasy-based euphoria, at the abandonment of all rational thinking. Markets do not function rationally; they function based on fear and greed. I have always been fascinated at the psychological aspect of the markets, and in my mind this is the number-one factor to consider when looking for a penny stock to buy: What is the “scared money” doing versus what the “strong money” is doing? If you can locate this (and you CAN by looking at price charts), you can tell what a stock has a high probability of doing, without looking at the first prospectus.

So the question of “Why penny stocks?” in my mind is answered when you understand that due to the extreme leverage of penny stocks, the greed-and-fear aspects of this particular market are more pronounced, producing also more pronounced price fluctuations, which can equal greater gains (or losses) depending on how you position yourself. I would be a fool to “guarantee” anything about the penny stock markets and especially about any particular penny stock, because again, the drivers of this market are so abstract that the best you can do is locate penny stocks that have a decent probability of making a run up, based on what the price charts are telling you. It really boils down to the risk and reward factor. There is outstanding potential for rewards in the realm of penny stock trading, but participating in this arena carries inherent risks that cannot be overlooked. The angle that I want to present, however, is the fact that there is a very persistent viewpoint regarding which stocks are “low-risk” versus “high-risk”. The usual assumption is that stocks that are lower in price-per-share are automatically more risky, but that is not always the case. Just think back to Enron—it was trading over $80.00 per share when it began to tank. It was a huge, well-known company with hundreds of employees. It was uniquely positioned in a competitive market. It was actually “sexy” too (LOL). By all accounts, it would be considered (and was considered by many) to be a “low-risk” stock to own, even a blue chip in some people’s minds. But lo and behold, the house of cards came tumbling down when greed and deception took over. Actually, the deception was due to the greed, so it all really stemmed from the ridiculous greed that those top execs in the company were operating in at the time. What I’m trying to say is that the concept of “low risk”, no matter how much we may try to justify otherwise, is really an illusion. ANY stock can tank. ANY company can fail. ANY accounting department of any company can “cook the books”. It doesn’t matter what the share price is, it matters what’s in the minds and hearts of the people that run the corporation, and the people who trade the company’s stock. This all may seem rather abstract “out of reach”, but it’s absolutely true. So how do you mitigate this risk? You keep in mind what Robert Kiyosaki has said so many times (and he got it from his “Rich Dad”): It’s not the investment that’s risky, it’s the investor that’s risky.

So what am I getting at? There are investors that made a FORTUNE from Enron’s demise. People who sold naked calls. People who shorted the stock all the way down. You know why? They knew how to manage THEMSELVES and their behavior in light of what the stock was doing. That’s where most people miss it. You cannot change the direction of the wind, but you can adjust your sail. The true stock trader/investor is a “gamer” of sorts. You have to be quick on your feet, you have to recognize when an idea is not panning out, and you have to adapt, improvise, and stay mentally nimble in order to manage risk as best as you can. A real trader is not “married” to the long side OR the short side. A real trader goes whichever way the market is telling him/her to go. This is my answer to “Why penny stocks?” Because I know and understand the risks involved, and I am prepared to govern MYSELF in light of what the stock is doing. I can’t change the stock’s price action, but I can change how I trade in light of what the stock is doing. I hope this makes sense. It’s really the only way to survive in these crazy markets.