The Perfect Way to Avoid the Penny Stock Trap

The Perfect Way to Avoid the Penny Stock Trap
By Andy Gordon
Date June 15, 2016

Investing is hard enough without being cheated, scammed or lied to.

You know the old rule of thumb. If it sounds too good to be true, it probably is.

Good example: penny stocks.

Sure, a $0.10 stock that moves up the coin ladder to a quarter will give you a 150% return. What’s not to like, right?

Turns out, plenty.

First off, the stock could just as easily move in the opposite direction. A dime stock that shrinks to a nickel stock will put you 50% in the red.

Did you notice it takes $0.10 to double your stake but only $0.05 to halve it? The ride down the elevator is much faster than the one up.

But the real danger of penny stocks is the potential for possible pump-and-dump schemes. If you’ve watched the movie The Wolf of Wall Street, you know what I mean.

These shares may be super-cheap, but gosh, they’re a scam waiting to happen.

It’s ridiculously easy for unscrupulous owners to pump these shares up by convincing unsuspecting investors to buy them, then dump them when they’ve increased $0.10 to $0.25.

So what to do if you’re the type of person who likes super-cheap shares? (I admit they’re hard to resist.)

A New Class of Shares With Extraordinary Upside

I have good news for you…

A new class of shares has recently become available thanks to the JOBS Act of 2012.

And it doesn’t matter how much you make, what your personal worth is, what your credit rating is, whether you owe taxes or if you’re behind on your alimony payments.

Why am I talking about something that happened four years ago as if it were new?

Because it’s taken the government four years to issue the necessary regulations for the JOBS Act. Ridiculous, I know, but that’s the government for you.

Thankfully, that’s all in the past. You (and everyone else you know) can now invest in small companies whose shares are just as cheap as penny stocks.

For example, I just added one of these businesses to my portfolio. Its shares were going for between $0.80 and $1.20 a year ago, and they’re now sitting at $2.33.

In a special report I published on the company, I said that its “ceiling is among the highest I’ve ever seen.”

This company is a startup, one of thousands that have raised money from individuals willing to take on extra risk to reap potentially extraordinary returns.

The risk? It’s that you’re investing very early. These companies usually have impressive revenue growth rates, but their long-haul profitability is not always firmly established.

As for fraud, it’s NOT part of the risk. The JOBS Act made sure of that. It has plenty of protective measures to prevent scams.

For example, it requires background checks on these companies. And they must go through online intermediaries.

Until recently, only professional venture capitalists, angel investors or well-connected financiers could invest in these companies that are so young and brimming with so much upside potential.

So this is a very new and exciting development. Investors would be foolish not to take advantage.

Taking the Biggest Risk off the Table

When you invest this early, you invest as much in the founding team’s continued execution of its growth strategy as you do its technologies or products. And that can make it tricky.

Another major concern – perhaps the biggest – is the one I’m going to tell you about right now. It’s likely very different from anything you’ve encountered in your stock investing experience.

Simply put, you lose more than you win.

Bad odds, right? Not necessarily. I’m going to show you how to work the numbers so that the odds work for you and not against you.

Even the richest startup investors have built portfolios that had, have and always will have more losers than winners. But these very same investors know how to play the odds.

I’m going to teach you the same trick they use to make small fortunes. Then I’m going to give you two specific startup investment opportunities that make use of this trick.

I can’t emphasize this enough. No matter how good an investor you are, most of your startups will be losers. And this is perfectly fine. Why?

Because startups are also capable of spectacular gains.

I’m not talking about 100% or even 200%. I’m talking about 1,000% or 20,000%… and in some cases, much more.

Let’s do the math.

When Facebook was raising its seed money, it was valued at around $5 million. Now it’s worth $333 billion, some 66,000 times its seed worth.

Granted, a company like Facebook doesn’t come around very often. So it’s worth mentioning that, just in the past few years, we’ve seen over 146 companies go from being worth a few million to more than a billion.

Every single one of them is returning a huge profit to their early-in investors.

And I estimate there’s double the number of companies with valuations between $500 million and $1 billion.

The question for you is: How do you play the odds to give you the best chance of landing one of these babies?

The answer: Put at least 20 companies in your portfolio. It’s how you make the odds work for you.

Let me explain why in a little more detail before telling you about the startup opportunities that will allow you to hit those numbers the fastest, easiest and cheapest way possible.

This Law Is Powerful

The secret has to do with what is called the “power law of distribution” (in this case, “distribution” of returns).

The power law lets one investment in one company cover all your losing bets. At that point, how much you make depends on whether your big winner is going up 10X, 20X, 50X or more.

The best way to explain this is to do some math.

Imagine investing $1,000 into each of 10 companies. And one of them starts out at a valuation of $4 million, eventually climbing to $80 million, or 20 times what you paid. Dilution (caused by the shares issued in later rounds to raise more money) cuts your profit in half.

You’ve still made 10X or $10,000. As for the other nine companies?

(Editor’s Note: I’ve put together a portfolio of startup companies for our Startup Investor members. Out of 28 companies, a couple are showing weakness and may fail. But I like to be conservative about these things, so let’s say that, eventually, a total of six, or 20% of the holdings in the portfolio, go under.)

Let’s be super conservative in our calculations and assume that five of the nine eventually fail. That leaves four companies that make between 2X and 5X, averaging out to a 3.5X gain.

For those four companies, each $4,000 stake you made turns into $14,000.

In all, you’ve made $24,000, or 2.4X on your $10,000 investment.

Typically, venture capital companies aim to make 3X, so we’re a little under that benchmark. But that makes sense since we used very conservative numbers.

That is how the power law of distribution works. Your big winners turn average portfolio returns into exceptionally profitable portfolios.

It’s like that for all early investors – from the smallest to the biggest.

And the more holdings you have in your portfolio, the better your chances of landing a big winner. That’s why I strongly suggest a portfolio of at least 20 startups.

My thinking is very simple here. If you have a pretty good chance of landing a big winner with 10 companies in your portfolio, your chances double with 20. They triple with 30. And so on.

Of course, time and money put limits on how many positions you can put into your portfolio. Twenty is the sweet spot.

With minimums as low as $100, 20 is affordable. I think it also represents the average maximum number of companies you can keep track of (although I realize this varies greatly from person to person).

Still, the idea of putting 20 startups into a portfolio one by one can be daunting. Evaluating these companies can be tricky, since many don’t have much of a track record.

That’s why, right now, I’m going to give you two ways to dive in – quickly, easily and cheaply.

Both of these investment vehicles offer you the opportunity to invest in outstanding portfolios. Write one check, and you’re immediately invested in multiple startups chosen by professional investors with deep knowledge of the field.

So here goes…

  1. SharesPost (Nasdaq: PRIVX) has been buying and selling secondary shares of startups since 2009. It now offers theSharesPost 100 Fund, which is made up of 32 late-stage, pre-IPO companies. Among the standout startups are DocuSign, Jawbone, Dataminr, Kabam and Prosper. The minimum investment is $2,500.
  2. GSV Capital Corp. (Nasdaq: GSVC) has quite a nice portfolio! Its 46 holdings include Lyft, Palantir, Spotify and Coursera. GSV is a business development company that makes both direct and secondary direct capital investments into late-stage, venture-backed private companies.
  3. Bonus Option: MicroVentures makes funds available for accredited investors only. For those of you with rising income levels, keep this one in your back pocket for later use. MicroVentures has had equal success accessing early- and late-stage companies. So, not surprisingly, it offers both early- and late-stage funds.

    For a minimum of $5,000, your fund will invest in six to a dozen outstanding startups. We’ve participated in both MicroVentures’ early- and late-stage choices and were extremely happy with the quality of the companies it puts in each. This business is well worth looking into.

    For individual investors, the accreditation verification process will ask you about your annual income or net worth. You can qualify by either a) having more than $200,000 in annual income (or $300,000 with your spouse) or b) having a net worth of at least $1 million (not including your principal residence).

For new startup investors, it’s a great way to make the power law of distribution work immediately for you.

In the future, I expect more funds will become available to non-accredited investors. In the meantime, you are now allowed to invest in individual startups as a non-accredited investor. And the minimums run as low as $100, making a 20-company portfolio quite affordable.

The best portals to access crowdfunding opportunities are Wefunder and SeedInvest.

It’s a new world of exciting investing opportunities. And investing in companies with great startup portfolios or funds is one of the best ways to get started and maximize your odds of landing a big winner.

Good investing,

Andy Gordon,
Founder, Early Investing

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