Will cheap stocks make you rich, or destroy your portfolio?

There’s a sure bet in the stock market that almost nobody plays. It’s a bet that will virtually guarantee you large returns over the course of your life.

There’s another bet in the stock market, however, that’s sure to devastate your portfolio the longer you keep making it. Ironically, this fool’s game is far more popular with investors.

Both of these bets fall under the general strategy of buying cheap stocks but the specific sub-strategy that you employ will have a enormous impact on your long term results.

How to Devastate Your Portfolio With Cheap Stocks

When most investors think of cheap stocks they think of stocks like Elite Pharmaceutical, which trades over the counter at 37 cents per share, or Hudson City Bancorp, a stock that trades below $9 per share. Most people are instinctively attracted to buying cheap stocks such as these — stocks trading at a low absolute dollar figure. We’ve all heard the adage “buy low, sell high” so it makes sense that investors would be drawn to these types of low priced stocks. When it comes to buying low, after all, you can’t get much cheaper than penny stocks, stocks trading below $1.

If you buy these these types of cheap stocks you probably see two major advantages to them. For one, since you’re paying so little for your stock there’s the perception that you just can’t lose. “How could I possibly lose on a stock that I’m buying for just $2?! I’m paying almost nothing for it!”

The other assumed benefit is the idea that cheap stocks such as Elite Pharmaceutical or Hudson City Bancorp have explosive profit potential. Many people think that it’s much easier for cheap stocks to double, triple, or quadruple in price compared to stocks priced at 20, 30, 50, or $100.

While it may or may not be true that cheap stocks have an easier time increasing in price, it’s definitely true that investor expectations about profiting through these types of cheap stocks is way out of line. If you want to make great returns by buying cheap stocks, you have to adjust your thinking.

The main problem with buying these types of cheap stocks — stocks trading for a low absolute dollar amount — is that you can actually lose quite a lot of money, even if they’re trading for just $2. The amount of money that you can lose is essentially the amount of money that you invested — $2 000, $5 000…. $100 000. If the company behind your $2 stock goes bankrupt then it doesn’t matter what the shares were priced at — you could still lose everything.

Do You Really Know What Cheap Stocks Are?

When my father first started looking for solid money managers I advised him to purchase stock in Warren Buffett’s Berkshire Hathaway. His ears perked up, wanting to hear more. I told him about Buffett’s fantastic record, the inherent diversification that comes with buying Berkshire Hathaway stock, and the likely returns going forward. Since so many money managers fail to beat the market, he was definitely interested.

But then he saw the price of Berkshire Hathaway’s Class B shares and stopped dead in his tracks. He just couldn’t get it out of his head that Berkshire Hathaway stock was extremely expensive.

Most people consider “cheap stocks” to be stocks that are trading for a low absolute dollar figure. My dad was no different — despite buying into the value investing philosophy. A lot of people look at the large cost per share of purchasing Berkshire Hathaway’s B shares and consider those shares expensive, while at the same time automatically assuming that stocks trading for below $1 are “cheap.”

Of course, the other way to think about cheap stocks is in terms of the price-value relationship on offer. This is exactly what I talk about when I mention cheap stocks to friends or those who signed up for free net net stock ideas.

If you nail this relationship then your portfolio will be well on its way towards high average yearly returns. In fact, picking a great strategy that exploits price-value discrepancies and then executing well on that strategy are two key factors in racking up returns that will make your friends jealous.

Cheap Stocks and the Essence of Value Investing

To get this point, it’s essential that you understand that every stock represents a piece of a business. At some point, management literally carved up their company into pieces and then sold off those pieces to individuals. Since the company as a whole is worth a certain amount of money, so are those individual pieces of the company.

A stock quote, on the other hand, is just the latest transaction price at which some of the company’s shares were exchanged. This price may or may not reflect the real world value — the value of the pieces of the company — that the shares represent. You wouldn’t think that your new Porsche 911 Turbo was worthless if someone offered you $10 for it, would you? Why would you think that your stock is worthless if it has been bid down to absurdly low levels?

Following this line of thinking, it should also be clearer why just buying based on a low absolute dollar amount can be so devastating. Ultimately, it doesn’t matter what the price of the shares are — it’s the relationship between the underlying business value and the price of the shares that matter. If you buy based on just a low absolute dollar amount and hype than you’d be completely ignoring the actual value of the shares — and there could ultimately be very little backing that share price…. and no solid reason for the shares to be worth even the low dollar amount that you paid for them.

Net Nets: Financially Devastating or Fantastic

Tiny packages can pack a powerful punch, but consistently high returns come from cheap stocks relative to value.

Recognizing that price is different from value and then buying when prices are well below underlying value is the essence of investing in cheap stocks.

Price can, and often does, swing around wildly in relation to value. Fortunately, price and value always seem to gravitate towards each other. That means that the price-value gap will close in time, no matter if it means the price rising to reflect value, the underlying value rising to reflect price, the stock price falling back down to earth, or the value falling so that it converges with the stock price.

While it’s true that you could buy overpriced shares in high quality companies and then wait for the value to catch up, this technique is far less lucrative, and far more risky, than buying cheap stocks. If you buy cheap stocks relative to value than if value falls your stocks are already undervalued so you are protected on the downside. More often than not, however, the price of the stock rises to reflect the value that it represents. In other words, since mean reversion is a fundamental law of the stock market, buying cheap stocks relative to value means protecting your downside while setting up a high probability chance that you’ll see large profits.

What I love about the stock market is that sometimes it causes people to do

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