If it’s done right, investing in penny shares is the way to go.
You can get great returns, and nothing matches the thrill you feel when one of your investments comes off the way you’d planned.
That said, to enjoy great investment returns, you need to get comfortable with risk.
If you want really big returns on a stock, you have to be willing to accept the possibility that you might lose some of what you’ve invested.
I’ve sketched out the relationship between risk and return on the graph below. Risk is represented by the red zig-zags, and return is shown by the blue trend line.
Basically, the bigger the zig-zags (the bigger the risk), then the steeper the slope of the blue line will tend to be (the bigger the return).
So you need to “make friends with” risk. Today, I want to show you how to do it.
What makes penny shares different?
Penny shares are different to normal shares in a couple of ways. You need to understand those differences if you’re going to maximise your profit, and manage your risk.
The first difference is that they’re much more volatile than the shares of big companies. They’re more volatile because a big FTSE 100 company can be literally tens of thousands of times larger than a tiny Aim stock. Like anything big, the value of a FTSE 100 company is hard to shift. Whereas some news or a change sentiment can send the value of a tiny Aim share flying.
Volatility is par for the course at this end of the market. You need to make your peace with it, and learn not to be stressed out by it.
The second difference is that Aim stocks have the potential to grow by 4, 5, even ten times. Large companies just can’t do that. Aim shares have been known to rocket up by 500, even 1,000% on a single day.
So what does this mean for how you manage risk?
The one simple rule
First – volatility plays havoc with some risk management techniques such as stop-losses. A stop loss is an order to automatically sell your shares if their price drops below a certain level. But volatile penny shares can easily bounce down to your stop loss level, which can cut you out of the trade at a loss.
Second – in penny shares, you find a small number of really big winners. These are the 500% or 1000% winners I mentioned above. Profits from your biggest winners make up for the stocks in your portfolio which lose money, or don’t ever take off.
Each of the companies I choose in my advisory service, The Penny Share Letter, has a real chance to double, triple or in some cases make you 10 times your money.
But you’re not going to succeed with 100% of your investments. In fact, you probably won’t even achieve success 75% of the time.
And that’s fine.
With penny shares, your winning percentage isn’t so important. It’s much more important to make giant returns when you’re right, but only lose small amounts of money when you’re wrong.
So if volatility means that stop losses are a no-no, and if one big win can make your portfolio, what’s the best way to manage risk?
The answer is to have a large number of small positions.
If you have a large number of different penny stocks in your portfolio, you’re giving yourself the best possible chance of unearthing a huge win – a 500% or 1000% gain.
We can’t know in advance which of the portfolio stocks will turn out to be the superstars. But if we spread our bets across a large number of penny shares, we’re giving ourselves the best chance of finding them.
Another reason to have a large number of positions: you want each position to be relatively small. Why is that? Well, since stop losses don’t work well with penny shares, you need another way to limit the amount of money you have at risk in each company. Using smaller position sizes is a smart way to achieve that.
For example, a £500 position with no stop loss carries the same risk as a £1,000 position with a 50% stop loss. Either way, you’re risking the same amount of money.
So take smaller positions than you normally would, and use the extra funds to take a larger number of positions. This will protect you from losing big on any one stock, and it’ll maximise your chances of buying the ten-bagger which makes your investing year.
What’s a sensible position size, overall? I’d advise that you don’t allocate more than 3% of your total portfolio to any one position.
So there you have it. Follow these suggestions and you’ve a great shot at a successful and stress-free career in the world of penny shares.
And remember, if you’re interested in finding out more about the kind of penny shares I advise people to invest in…
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