I have $1000 to invest. I use Scottrade to invest in penny stocks online, they charge $7 to buy a stock and another $7 to sell it ($14 in total). Given the high volatility of these stocks, what tactic should I use in order to maximize my EXPECTED RETURN? Expected return => (taking into account the potential returns of each tactic and its probability of success) Should I invest all $1000 in one stock or should I invest in two, three, ... ?

Thank you for your time.

  • 23
    Why do you want to use this $1000 to invest in penny stocks? – BrenBarn Mar 4 '14 at 6:15
  • 9
    Put on reds, I tell you! – littleadv Mar 4 '14 at 6:22
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    This is a legitimate question and relevant to this community. – William Entriken Mar 4 '14 at 14:52
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    Penny stocks are a gamble. The only way to maximize your return is to be lucky. – Bruce Alderman Mar 4 '14 at 16:25
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    I always put it on black, that's the safer bet. – Steven Leggett Mar 4 '14 at 17:27

I am voting you up because this is a legitimate question with a correct possible answer. Yes, you shouldn't buy penny stocks, yes you shouldn't speculate, yes people will be jealous that you have money to burn.

Your question: how to maximize expected return. There are several definitions of return and the correct one will determine the correct answer.

  1. Expected value: this is the arithmetic average of possible outcomes weighted by their likelihood. It is the correct choice when evaluating a specific decision/project where you will end the venture after the decision instead of completing it continuously.
  2. Maximize geometric return: this is the geometric weighted average of outcomes. It is the correct choice when you will be repeating a decision/algorithm over and over. It is optimized by The Kelly Criterion and it deathly afraid of going bust (since in the long run one bust makes everything else irrelevant).
  3. Risk-adjusted return: is the valuation of a portfolio performance when compared versus a comparable asset class, see Sharpe Ratio. This is the correct choice for choosing the best portfolio manager when different levels of risk are available. (A great bond fund is better than a shitty equity fund, even though it is expected to return less.)

For your situation, $1,000 sounds like disposable income and that you have the human capital to make more income in the future with your productive years. So we will not assume you want to take this money and reinvest the remains until you are dead. This rules out #2.

It sounds like you are the sole beneficiary of this fund and that your value proposition is regardless of asset class and competition to other investment opportunities. In other words, you are committed to blowing this $1,000 and would not consider instead putting the money towards paying down credit card debt or other valuable uses. This rules out #3.

You are left with #1, expected value.

Now there is already evidence that penny stocks are a losing proposition. In fact, some people have been successful in setting up honeypot email accounts and waiting for penny stock spam... then shorting those stocks. So to maximize expected return, invest 0% of your bankroll. But that's boring, let's ignore it.

As you have correctly identified, the transaction costs are significant, $14 in tolls on crossing the bridge both ways on a $1,000 investment already exceeds the 5-year US bond rate. Diversification will affect the correlation and overall risk (Kelly Criterion) of your portfolio -- but it has no effect on your expected return.

In summary, diversification has zero effect on your expected return and is not justified by the cost.

  • 4
    This is a great answer, very well justified. – ChrisInEdmonton Mar 4 '14 at 15:33
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    +1 - a fine example of an answer that I disagree with, but so well presented it's a fine counterpoint to much of my answer. (Disagree is a difference of opinion. I am not suggesting right/wrong) – JoeTaxpayer Mar 4 '14 at 16:04
  • Expected value is calculated geometrically. Arithmetic means have no place in finance. Also, the stock market version of Kelly must be used. – user11865 Mar 4 '14 at 16:08
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    @quantycuenta From Thorps paper on Kelly & stock market "Thus the criterion of betting to maximize expected gain is a fundamentally undesirable strategy" used arithmetic average for expected gain. In general use arithmetic mean for superposing possibilities at the same time point and geom mean for combining results across time. – William Entriken Mar 5 '14 at 0:46
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    That is precious! +1 to that comment. I hope all of my competition does math that way. – user11865 Mar 5 '14 at 14:05

If you want to put in $1000 into penny stocks, I wouldn't be calling that investing but more like speculation or gambling. You might have better odds at a casino.

If you don't have much money at the moment to invest properly and you are just starting out as an investor, I would spend that $1000 on educating yourself so that by the time you have more money to invest you can come up with a better investment strategy.

  • 2
    Good answer. And if you are just speculating or gambling, then don't worry about risk. Just be ready to lose $1000. – Joe Strazzere Mar 4 '14 at 12:18

There's a grey area where investing and speculating cross. For some, the stock market, as in 10% long term return with about 14% standard deviation, is too risky. For others, not enough action.

Say you have chosen 10 penny stocks, done your diligence, to the extent possible, and from a few dozen this is the 10 you like. I'd rather put $100 into each of 10 than to put all my eggs in one basket. You'll find that 3 might go up nicely, 3 will flounder around, and 4 will go under. The gambler mentality is if one takes off, you have a profit.

After the crash of '08, buying both GM and Ford at crazy prices actually worked, GM stockholders getting nothing, but Ford surviving and now 7X what I bought it for.

Remember, when you go to vegas, you don't drop all your chips on Red, you play blackjack/craps as long as you can, and get all the free drinks you can.

  • 1
    Good answer. It's like taking 10 home run swings. Chances are you'll have 10 strikes. But if you connect on one, it could go a long way. – Joe Strazzere Mar 4 '14 at 13:33
  • How many different stocks would you want to invest in, so that if you do hit a home run, it makes up for all the strikes? – stannius Oct 5 '15 at 20:34

I've never invested in penny stocks. My #1 investing rule, buy what you know and use. People get burned because they hear about the next big thing, go invest! to just end up losing everything because they have no clue in what they're investing in.

From what I've found, until you have minimum of $5k to invest, put everything in a single investment. The reason for this, as others have mentioned, is that commissions eat up just about all your profits.

My opinion, don't put it in a bond, returns are garbage right now - however they are "safe". Because this is $1000 we're talking about and not your life savings, put it in a equity like a stock to try and maximize your return. I aim for 15% returns on stocks and can generally achieve 10-15% consistently. The problem is when you get greedy and keep thinking it will go above once you're at 10-15%. Sell it. Sell it right away :) If it drops down -15% you have to be willing to accept that risk. The nice thing is that you can wait it out. I try to put a 3 month time frame on things I buy to make money.

Once you start getting a more sizable chunk of money to play around with you should start to diversify. In Canada at least, once you have a trading account with a decent size investment the commissions get reduced to like $10 a trade. With your consistent 10% returns and additional savings you'll start to build up your portfolio. Keep at it and best of luck!

  • 1
    Don't panic sell if it seems like a minor glitch in the company you're invested in. I've done that repeatedly, from what I've found, panic selling is pretty much a blip that you need to be comfortable in over the long term. If you sell you're guaranteed to loose money now. If you wait, you chance it coming back to your original goal. In my case I should have waited - I would have made money – Steven Leggett Mar 5 '14 at 1:36
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    @Victor: Then you'd lose your money, which is why you diversify. Put simply if you aren't willing to watch a stock drop 10-15% then you shouldn't buy stocks. The reason is that everything you buy will take a dip at some point. If you sell it as soon as that happens, you'll be selling at the bottom of a temporary dip a lot more often than you're selling at the start of a long slide. You cannot time the market, you don't have the analysis tools. Unless you do of course, in which case go ahead with your technical analysis :-) – Steve Jessop Mar 5 '14 at 2:44
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    @SteveJessop - What I want to know and try to understand is why would you risk 100% loss for a 15% gain? Why would you get out of a stock that is performing well fundamentally and rising in price week after week for just a 15% return, but then be willing to hold another stock which has fallen 15%, 20%, 30% or more because you're afraid to take a loss. – Victor Mar 5 '14 at 2:51
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    @SteveJessop - yes, because this is the strategy Steven Leggett has shared in his answer. And I would question someone making consistent gains when they are taking a small profit at a time for each trade but are willing to take a big loss to achieve it, which could wipe out all your small gains in one go. – Victor Mar 5 '14 at 3:04
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    I fail to spot where the OP asked for general investing advice. The question was specifically about penny stock speculation. You flat-out admit that you've never even attempted to invest in penny stocks, and there isn't sufficient context in the question to justify the recommendations here, regardless of whether or not they work for you or others. I just don't see the relevance of any of this. – Aaronaught Mar 6 '14 at 0:13

These stocks have no value to them, are just waiting for paper work to liquefy and vanish. The other gamblers are bots waiting for some sucker to buy so they can sell right away. So maybe a fresh new penny stock that hasn't been botted yet gives some higher chance of success, but you probably need to be a bot to sell it quickly enough. All in all not that much different from buying regular stocks...

  • I am modding up for the funny and the insight, although this should have probably been a comment to the original question. – William Entriken Sep 8 '15 at 18:30

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