Nowadays, for most people, investing remains the most effective way to protect your capital against inflation which also helps to grow your wealth. For many that choose to do so, the stock market is a typical investment destination due to its solid long-term track record. 

By the stock market, we were referring, of course, like most people do, to the large companies that make up the major stock indexes such as the S&P500, NASDAQ, or the Dow Jones Industrial Average. However, these are by no means the only companies that have chosen to go public and are available for investors. 

In fact, some people take part in a rather little-explored area of finance and go on to invest in penny stocks - very small companies that are trading for $5 and below. Are these people just choosing a way to invest that doesn't work, or are penny stocks actually a good way to invest your money? Let's explore.

The basics

As mentioned, penny stocks typically trade below $5 and are very small companies. They are deemed to have little potential, as many of them have small revenues, and most penny stocks fail within a few years. However, make no mistake - those that do make it, may earn you hundreds of times your initial investment.

A Simple Choice

The idea of investing in penny stocks can be depicted with a simple choice: If you decide to buy a penny stock, you will have: 

A Small Chance of Unlimited Upside, A Good Chance of Limited Downside

Whereas if you decide to short-sell a penny stock, you will have:

A Good Chance of Limited Upside, A Small Chance of Unlimited Downside

Both ways can be used to make a profit. What is crucial here, however, is that the first option will seem much more appealing due to the ability to directly control how much risk you take - since your downside is limited, whereas your upside is unlimited. Let's illustrate this by some simple math.

Simple Math

If you invest in a penny stock trading at $0.12, and it grows to become a $133 stock, you will have multiplied your investment by a factor of 1,000. That is, you will have grown an initial investment of $1,000 into a million dollars. 

First, this has happened before, as the company which experienced such growth is none other than Apple. Yes - Apple, back in 1997 was merely a penny stock, trading just for that - pennies on the dollar.

Second, it is important to understand that while the odds are against you (most penny stocks do fail), you would need to pick over a thousand failing stocks in order to get nothing out of a single successful investment such as Apple, if you invested the same amount with every penny stock. 

This shows just how lucrative investing in penny stocks can be - and you are going to get better at picking the winners with time too. Even if you are not comfortable with investing it all only in penny stocks, including them as part of your stock portfolio can significantly increase your overall returns. You can read more about the idea of value investing in penny stocks in this informative article called "Are Penny Stocks Compatible With Value Investing?". 

Pitfalls of investing in penny stocks

As with all investments, penny stocks carry a few potential downsides. Due to their size, they often become targets of pump and dump schemes. Such schemes are put in place in order to exploit the vulnerability of penny stock prices. A pump and dump scheme works by the interested party pumping the price of a penny stock up, just to spark buying interest from other investors. As soon as unaware investors flock to buy the penny stock, the interested party sells all of their holdings and crashes the price, leaving the victims in the red. Therefore, knowledge of the market is key and will help you not fall victim to such schemes.

Another downside of investing in penny stocks is the fact that it takes time and money to find winners. Therefore, you may go on to invest into multiple companies with no luck and no return until you hit your first goldmine. That said, however, by having penny stocks only as part of your overall portfolio and using the principles of value investing, you will be able to overcome this downside.

Investing in penny stocks can be a tremendously powerful way to grow your wealth. However, due to the relatively unexplored field that investing in penny stocks is, knowledge and experience are key if you are to be successful at it. For many, finding a mentor who can not only introduce, but also explain in detail the intricacies of the market to you, is the way to go.