How Much Should You Allocate to Penny Stocks?

Penny stocks have become the favourite category for many retail individuals, especially first-time investors.

These investors flock towards penny stocks with the hope of making big money in them.

Penny stocks are stocks that trade at very low prices and market capitalisation and are not part of any major market index.

Investors typically prefer to buy into these stocks hoping that over time the stock price will appreciate and it will become the next Infosys or Bajaj Finance.

But just because the risk-reward ratio seems extremely high here, it doesn't mean that penny stocks will make an investor rich.

As a group, penny stocks have certainly destroyed a lot more shareholder wealth than any other.

Penny stocks are also a grey area in the market wherein operators and traders come to play. Eventually when the penny stocks stop being 'played' by operators, retail investors get stuck.

That is why it's important you manage your allocation towards penny stocks.

The exponential rise of penny stocks in a bull market

Not surprisingly, the bull market we witnessed in the past 15-18 months has sent some of the penny stocks to rise exponentially.

In fact, as can be seen from the chart below, stocks have rallied by almost 7,000%, 70-baggers in just one year!

The rally in penny stocks during bull markets is nothing new. These stocks typically explode when markets rise.

Being low in liquidity, it's relatively easy to manipulate their stock prices. And a market rally typically acts as a camouflage for these stocks.

However, investors should not get carried away by high returns from such stocks. While some may have rallied on the back of improved fundamentals, the rally in others could be misleading.

Basically, investors should exercise caution when dealing in penny stocks as the risk is high.

How to select the right penny stocks?

In penny stock investing, it is very important to distinguish between penny stocks that are investment worthy and the ones that are highly speculative.

That is why, Co-head of Research at Equitymaster, Rahul Shah has developed an in-house system which has been able to do this with a very good success rate.

Equitymaster's penny stock recommendation service Exponential Profits, has a SOLID framework for penny stock investing.

S stands for strong balance sheet, O for Owner Operators, L for long term business viability, I for Income generating, and D for deeply discounted valuations.

And with the help of this SOLID framework, Rahul has closed the past 26 consecutive recommendations with big gains...gains like 105% in a little over a year, 82% in less than three months, 70% in less than 2 months, and 64% in 5 months.

That's a solid track record by any margin.

So if you don't want to hassle around searching for fundamentally strong penny stocks, we highly recommend you sign up at Exponential Profits and check out the Top 5 10X Stocks for 2022.

Or if you want to invest in penny stocks on your own, study the fundamentals of the company rather than just looking at recent price data.

If the company fundamentals are sound and the stock is available at attractive valuations, then go ahead and buy it. Otherwise stay away from it.

The process remains the same irrespective whether the stock is a penny stock or a large cap one.

The best allocation towards penny stocks is...

Penny stocks are inherently riskier than bluechip or midcap stocks.

On the brighter side, they present a huge growth potential. It's not unusual for a good penny stock to turn into a multibagger in a matter of months.

On the flipside, there is a high risk attached to them. Not all penny stocks tend to be outperformers. In fact, there are instances where penny stocks have plunged 80-90% when things turned sour.

That is the reason penny stocks are not recommended to those having a low risk profile.

If you have an appetite for slightly more risk, it's recommended that not more than 5%-7% of one's portfolio be invested in penny stocks.

This means that the corpus that one sets aside for penny stocks should not be more than 5%-7% of the total money allocated towards equities.

For better understanding of the portfolio allocation towards penny stocks, we reached out to Rahul Shah and asked him this question:

• If you were sitting on cash today, had the risk appetite, and a tenure of 3 years, how would you allocate money? Also, what role would penny stocks play in this? Let's take Rs 100 in cash...

Here's Rahul in his own words:

• The market has already gone up more than 2x from its lows. Therefore, this is not the time to take maximum exposure to penny stocks.
  
  If I had Rs 100 today and if I was investing in penny stocks from a 2-3 year perspective, I will maybe take only 50% exposure to penny stocks or even as low as 25% and keep the remaining in bonds or FDs.
  
  Thus, in the future when the markets correct, I can take the exposure to as high as 75% of the overall corpus dedicated to penny stocks.
  
  This, in my view, is one of the best ways to maximise profits and minimise losses from a space as volatile as penny stocks.

Just last week, Rahul recorded a video showing the top penny stocks for 2022 that will minimise your downside and also promise a good upside.

If you haven't checked it yet, you're in for a treat.

Happy Investing!

Disclaimer: This article is for information purposes only. It is not a stock recommendation and should not be treated as such. Learn more about our recommendation services here...