Penny stocks hint at the promise of overnight riches. A look at the volatility of these cheap positions might lure you into the dream of doubling or tripling your money fast. Simply deploy $5,000 on shares of a $0.50 stock, and then sell your holdings when the share price reaches $1. That's only a $0.50 gain, which isn't much, right?
While there are penny stock success stories, it's far more likely this style of investing will bring you more losses than gains. Maybe you were lucky enough to invest in miner IAMGOLD (NYSE: IAG) when it bottomed at $1.88 in March. And then you were equally inspired to sell that position in May after the share price skirted above $3.50.
But what if you had instead jumped on the opportunity to buy J.C. Penney (NYSE: JCP) when the share price fell below $1 in January? You could have been wiped out by the bankruptcy filing that sent the retailer's share price tumbling down to the $0.20 mark in mid-May.
In reality, the risk of cheap stocks far outweighs the rewards. That rule actually holds true for all financial strategies that offer the possibility of quick rewards. If you can win big, you can also lose big. Unfortunately, the losses happen more often than the wins.
So, what's a retirement saver to do? The real answer to wealth building is far less thrilling. It involves saving regularly and investing in a diversified portfolio that's appropriate for your risk tolerance and timeline.
Save early and often
The earlier you start saving for retirement, the less reliant you'll be on big wins in the stock market. Even modest returns can generate a lot of wealth when you have 30 to 40 years to invest. The table below shows how much wealth you can accumulate over time at different levels of monthly savings. This assumes a 6% average annual growth rate, which is less than the stock market's historical long-term average after inflation of 7%.
Balance After 10 Years
Balance After 20 Years
Balance After 30 Years
Balance After 40 Years
What the table doesn't show is the composition of those final balances, between the money you contributed and the earnings off those contributions. When you save $100 monthly for 40 years, your savings contributions total $48,000. The remaining $150,000 or so is all earnings -- a quadrupling of your investment.
Also, the numbers assume you are saving in a tax-advantaged 401(k) or IRA. These accounts defer the taxes on your investment earnings, which keeps you from having to pull money out each year to pay the IRS. Invest your retirement portfolio in a taxable account, and your wealth accumulation will be slower. Assuming a combined state and federal tax rate of 25%, for example, saving $100 monthly for 40 years at the same 6% return would equate to $162,109 after taxes -- a reduction of nearly $40,000.
Diversification in your portfolio supports your wealth-building efforts by limiting risk. Simply put, the more positions you hold, the less dependent you are on any one of them. And when you hold positions that respond differently to market conditions (say, stocks versus bonds), you can insulate yourself against the wildest of market swings.
To diversify with individual holdings, you need 20 or more positions. It takes a lot of research to pick that many stocks and then track them over time. A simpler alternative is to invest in exchange-traded funds (ETFs) or low-cost index funds, which are already diversified. ETFs are highly liquid because they trade on the exchanges the same way stocks do. And index funds ensure performance near the market level by mimicking the holdings of major indexes like the S&P 500.
Risk tolerance and timeline
Investing according to your risk tolerance and timeline is important, because it reduces the likelihood that you'll sell when your positions are down. If you're invested too aggressively for your tolerance, one bad market turn could prompt you to panic and dump your holdings. And if you need to use the funds within the next five years, you may end up selling at a low point out of necessity.
You can reduce risk by avoiding penny stocks, for one. Instead, invest in stable sectors like consumer staples and utilities. You could also increase your debt holdings relative to your equity holdings. A 50/50 mix of stocks and bonds is more conservative and less risky than a portfolio with only 20% bonds and 80% stocks.
Build wealth the boring way
Penny stocks are like lottery tickets: Most are worthless. Yes, there's a tiny chance you'll strike it rich, but leaving your retirement plan to chance is the same as not planning at all. Go the reliable route and start saving and investing now. If you build a diversified portfolio that you can hold for the long term, you'll see far more predictable results.
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