Penny stocks have quite the reputation for having exceptionally high risk but can sometimes deliver spectacular returns. These are tiny publicly traded businesses with a market capitalisation of less than £50m. As such, the share price is often only a couple of pennies, hence the name.

In fact, these companies are so small that they cannot be found on large exchanges like the London Stock Exchange, New York Stock Exchange, or Nasdaq. Instead, investors seeking to tap into this region of the stock market will have to go to an Over-The-Counter (OTC) exchange. Here in the United Kingdom, we also have the Alternative Investment Market (AIM), which is home to many British penny stocks.

How to pick a good penny stock

The basis of any good investment strategy is sound research, and the same applies when searching for the best penny stocks.

However, in the case of penny stocks, information is not easily available. Because of low trading volumes and small size, these businesses typically aren’t on the radars of financial institutions.

Consequently, the level of coverage is often minimal, forcing individual investors to dig into weeds directly. While penny stocks have slightly looser regulator reporting requirements, they’re still obligated to provide vital documents like annual reports and other critical financial statements.

These documents can be a bit tricky to assess and require time to dissect. But they do speak volumes about the underlying small company when analysed correctly. Investors will discover what the business does, its financial position, the long-term strategy, who’s running the show and other critical information needed in making an informed investment decision.

Picking a good penny stock requires significantly more due diligence compared to looking at a blue chip stock. Their tiny size makes them far more susceptible to external threats, limits access to capital and often has to prove their product or service can penetrate into a market dominated by industry titans.

This is why many investors simply steer clear of penny stock investing entirely.

What are the risks of investing in penny stocks?

An investor can often enjoy massive triple-digit returns if a penny stock is successful. But that’s a big if.

While there are exceptions all too often, these companies don’t have a revenue stream or even products on the market. And the few that do are typically dependent on only a handful of customers for the bulk of their revenue stream, with no path to profitability in sight.

As a result, most are almost entirely dependent on external financing – specifically equity. After all, with no cash flows and low liquidity, taking debt can be a dangerous move.

That means these stocks constantly seek to build excitement and momentum that can push a share price to high levels so that new shares can be issued at a good price to raise capital.

This unfortunate reality is what makes penny stocks so volatile. Good news can send the share price skyrocketing, but the slightest sign of trouble, and it’ll come crashing back down to Earth.

For short-term swing traders, trading penny stocks is a great sandbox to play in. For long-term investors, the business has to prove itself and eventually generate enough growth and value to undo the equity dilution from constantly issuing shares.

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Another factor to consider is market liquidity. Since these are tiny businesses with small followings, the average trading volume can be seriously low. As such, the spread in the buying and selling price of the stock can be wide.

This results in lower-than-expected returns when trying to close a position. In the worst-case scenario, no one may be interested in buying the shares from investors trying to sell or vice versa.

These are just some of the reasons why penny shares are considered risky investments.

Are they good for beginners?

Deciding on an investment strategy and which asset classes to buy is a highly personal decision. Someone with little patience will likely struggle to succeed as a long-term value investor. Similarly, an individual with no stomach for risk will probably fail as a trader.

Therefore, whether or not penny stocks are suitable for a portfolio comes down to risk tolerance, time horizon, and financial goals that vary from person to person.

However, given the analytical skills and emotional temperament required to be a penny stock investor, most financial advisors agree that it’s not a suitable place for beginner investors.

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Is it wise to invest in these stocks?

Penny stocks are generally only suitable for investors who have a high-risk appetite. An early investment into these tiny businesses will often fail to deliver on expectations. But in the end, one success can easily wipe out multiple failures. That’s why diversification is a critical risk-reduction strategy when venturing into this space.

Do I pay taxes on penny stocks?

Buying a penny share or any other small-cap listed on the Alternative Investment Market here in the UK doesn’t exclude the standard stamp duty tax. However, any capital gains or dividends are still subject to the standard investment taxation rules.

However, using a tax-efficient account such as a Stocks and Shares ISA or Self-Invested Personal Pension (SIPP) enables British investors to delay or outright avoid these taxes.

Can I lose more than I invest in penny stocks?

If I invest in a penny stock using a standard investment account, then the maximum I can lose is the total I invested in the first place. However, traders often like using leverage in a margin account to amplify their gains. Yet, this also amplifies the losses. So, if I buy a penny stock using a margin, it’s possible to lose more money than I initially put in.

Investing with margin is typically reserved for experienced investors or traders and is generally unsuitable for beginners.

Saima Naveed does not own shares in any of the companies mentioned. The Money Cog has no position in any of the companies mentioned. Views expressed on the companies and assets mentioned in this article are those of the writer and therefore may differ from the opinions of analysts in The Money Cog Premium services.