Buy low and sell high is the ultimate winning strategy in the stock market. But some investors take this literally and buy very low-priced stocks. Also known as penny stocks, these scrips are not necessarily good investments. Since the market cap is low, they are easily manipulated by operators who lure unsuspecting investors and dump worthless shares on them. They first create a buzz around a stock, indulge in circular trading to push up the price, and then nudge investors to buy at high prices. As the tables show, a few penny stocks have given phenomenal returns in the past six months. Equally, some others have destroyed wealth during the same period.
The other problem is that penny stocks are thinly traded and even if the price zooms in the next few days, you may not be able to off-load all the shares. Any attempt to sell in large quantities only brings the price down.
What you should do: A penny stock is never a good investment, because you are buying it only in the hope of 'finding a bigger fool' who will buy it at a higher price. If a share is priced low, it is because the market does not see value. Study the fundamentals of the company. That will give you enough reasons to avoid pouring money into the junk shares.
BUYING OVERVALUED STOCKS
One can go wrong even with the blue chips. Small investors often get carried away by the market euphoria ignoring the 'value' of the stock. A good stock at a very high price is not a good investment. This overvaluation can happen even at the broader market levels. We studied the Sensex PE and its returns over the past 20 years and found that when the market was overvalued, the one-year average returns were very poor (see graphic).
What you should do: Pay attention to valuation when you buy a stock. Even if the company is growing very fast, avoid investing in it if the stock—or the market—is overvalued.
FALLING INTO VALUE TRAPS
Buying a stock just because the price has fallen 50 per cent from its peak is not always a good proposition. You may end up in a value trap. Investors who go hunting for bargains in the initial phase of a bear market also get into the value trap. They compare the current price and PE multiples with the earlier peak and start buying because the stock is available 'at a discount'. However, the price may continue to fall and losses could mount.
What you should do: Most all-time peaks are scaled during extreme euphoria in the market and, therefore, do not represent the real value of that stock. Similarly, it is not fair to judge the current valuation of a stock by comparing it with its all-time high valuations.
Instead, compare the current valuation with average valuations for the past 5-10 years. You also need to know why the valuations came down. Avoid buying if the fall is due to a decline in growth rates or if the industry is in trouble. Stocks with corporate governance issues usually quote at cheap valuations, buying them is not great idea. Besides, technical analysis says that a stock which has come down to a 52-week low after a long rally indicates that the tide is turning against the counter. This should be treated as a sell signal and not a buy 'at a discount' signal.
BUYING FUTURES & OPTIONS
Be greedy when they are fearful is what stock gurus advise. But some investors are greedier than they can afford to be. They get into the high-risk arena of futures and options (F&O) even though they don't have the financial muscle or the acumen. People who missed the initial phase of the market rally may now want to catch up by taking high-risk bets. The F&O segment allows an individual to buy up to five times the margin kept with the brokers. This means that with a margin of Rs 50,000, one can take a position in shares worth Rs 2.5 lakh. But while your gains can be five times greater, so can your losses.
What you should do: Whether it is the F&O market or the cash segment, don't bite off more than you can chew. F&Os are meant for hedging and retail investors should get in there only for hedging their existing portfolio. They can get into the speculative part later, but only after learning enough about the F&O market and the risks involved there.
FAQs
Based on a 32-year study of US equity performance, an investment strategy that succeeds in avoiding value traps provides better upside potential through more concentrated yet less risky exposure to the least expensive stocks. Screening out characteristics that signal value traps is a simple way to achieve this.
How do you avoid value traps in stocks? ›
To avoid falling into a value trap, investors should conduct thorough research beyond just financial ratios. Analyzing the company's competitive position, industry trends, management quality, growth prospects, and potential risks is essential.
How to spot cheap stocks and avoid value traps? ›
Competitive Position And Market Share
Check to see if a company is losing market share to rivals while evaluating its competitive position; this can frequently indicate a value trap. A declining market share could indicate a non-competitive business strategy for the corporation.
Should you avoid penny stocks? ›
Penny stocks are among the market's most dangerous stocks, so you may pay a much greater price than you first expect, including potentially losing all of your investment. Here's what a penny stock is and why it's so risky to investors looking to grow their wealth.
Is investing $1 in stocks worth it? ›
Investing $1 a day not only allows you to start taking advantage of compound interest. It also helps you to get comfortable with investing and develop the habit of putting your money to work for you. As you can see, that single dollar can make a huge difference in helping you to become more financially secure.
How to tell if a stock is a value trap? ›
For a value trap investment, the low price is often accompanied by extended periods of low multiples. Investments might be value traps if a company is experiencing financial instability and has little growth potential, leading to low multiples and growth potential.
How do you avoid traps in trading? ›
Wait for the price to move above the resistance level or swing high. You may consider entering a short trade if the price falls back below the resistance level, as the move higher was a false signal. There are additional tools that can be used for confirmation, such as technical indicators or candlestick patterns.
How do you find undervalued stocks like Warren Buffett? ›
Examples of what Warren Buffett looks for when looking for undervalued growth stocks include:
- Clear and understandable business model.
- Favorable long-term prospects.
- Unique competitive advantage.
- Strong earnings.
- High return on equity.
- Stable profit margins.
- Honest leadership.
Cheap stock refers to equity awards issued to employees ahead of an initial public offering (IPO) at a value far less than the IPO price. A venture that is not yet a public company may compensate employees with employee stock options or restricted stock units.
How to identify traps in the stock market? ›
Identifying a bear trap in the chart is quite simple. It occurs close to the support line. There is a downtrend accompanied by a high volume trade. A trap is confirmed when the trend reserves within five candlesticks, forming above the support line and the trend rapidly crosses the resistance level.
Yes, you can make money with penny stocks, but you can also make money playing the lottery, though you probably won't. To make money in penny stocks, you have to be able to separate the good companies from the bad, and that means you have to be able to analyze companies.
What is the rule of 72 in finance? ›
Do you know the Rule of 72? It's an easy way to calculate just how long it's going to take for your money to double. Just take the number 72 and divide it by the interest rate you hope to earn. That number gives you the approximate number of years it will take for your investment to double.
Are penny stocks a waste of money? ›
At best, penny stock companies are unproven and small, with dubious long-term prospects for success; at worst, the penny stocks are vehicles that con artists use to take advantage of unsuspecting investors. Many penny stocks are traded so cheaply because the businesses behind them aren't worth much more than that.
How to be a millionaire in 1 year? ›
It's Almost Impossible. While some experts believe it's an achievable feat, others aren't so optimistic. “It is almost impossible for most people to become millionaires within just one year,” said Loretta Kilday, attorney and spokesperson for Debt Consolidation Care.
Can the S&P 500 make you a millionaire? ›
Over long stretches, the starting point hardly matters in the grand scheme of things. The Vanguard S&P 500 ETF can definitely make you a millionaire one day. All it will take is patience and discipline.
How to become a millionaire in 30 years? ›
Assuming that you can earn this 10% average return over your investing career, if you are getting started investing this year and you want to become a millionaire in 30 years, you would need to invest $506.60 per month. This amount may seem like a lot, but it may actually be pretty doable for many people.
How do you filter undervalued stocks? ›
Price-to-earnings ratio (P/E)
A company's P/E ratio is the most popular way to measure its value. In essence, it shows how much you'd have to spend to make $1 in profit. A low P/E ratio could mean the stocks are undervalued. P/E ratio is calculated by dividing the price per share by the earnings per share (EPS).
What is the most accurate way to value a stock? ›
The most common way to value a stock is to compute the company's price-to-earnings (P/E) ratio. The P/E ratio equals the company's stock price divided by its most recently reported earnings per share (EPS). A low P/E ratio implies that an investor buying the stock is receiving an attractive amount of value.
Is PayPal a value trap? ›
Therefore, PayPal may not be a bargain after all. It may be a value trap that lures investors with a low valuation but fails to deliver growth or profitability.
