Penny stocks have been decimated lately. With economic conditions worsening, these tiny enterprises have seen their ability to raise capital through equity evaporate. Meanwhile, debt is also becoming prohibitively expensive.
So it’s not surprising the UK’s penny stock index – the FTSE AIM 100 – has dropped over 40% in the last two years. And this downward momentum has continued into 2023, with the index falling by another 10% since the start of the year.
Such volatility is why these tiny enterprises have a reputation for being risky. But now that economic conditions are improving, so are these firms’ operating environments. As such, capitalising on the depressed valuations of promising small-caps could unlock spectacular returns – far more than high-interest savings accounts.
Penny stocks vs saving
Interest rate hikes make life expensive for businesses and consumers, especially those on a variable-rate mortgage. But the one positive from this change in monetary policy is that savings accounts are finally yielding some meaningful gains.
Banks are now offering interest rates of around 4-5%. And with savings insured up to £85,000, these gains are almost entirely risk-free. That’s certainly nothing to scoff at, especially considering it wasn’t too long ago when savers were lucky to get more than 1%. But compared to the explosive potential of a successful penny stock, this return pales in comparison.
Suppose a young enterprise manages to beat the odds and turn into a stock market sensation? In that case, the returns can easily climb into the triple- or even quadruple-digit territory within a few years. And these gains are only amplified for investors able to get in when stock prices are depressed (like they are right now).
Risk vs reward
As exciting as the prospect of a 1,000% investment return sounds, investors need to take a step back. Penny stocks have tremendous growth potential. But there’s no guarantee that this potential will be realised. In fact, in most cases, these enterprises get elevated by investor excitement only to collapse a while later due to lack of substance.
The high-risk reputation of these businesses is well-earned. And a poorly researched investment fuelled by delusional expectations will most likely destroy wealth rather than create it. Hydrogen-related stocks are a perfect recent example of this, with firms like ITM Power surging to over 700p in 2021 only to collapse to under 100p today.
Therefore, it’s usually prudent to make penny stocks a relatively small proportion of an overall investment portfolio when venturing into this space. After all, if an investment is successful, investors won’t need to allocate much capital to reap tremendous rewards.
It’s also critical to diversify. Why? Because the threat of external factors is much higher compared to larger, more established enterprises in the FTSE 100.
By combining smart capital allocation with risk management, it’s possible to build a solid investment portfolio capable of far exceeding the performance of a high-interest savings account.
