Here’s how Not to invest in marijuana stocks

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Cannabis stocks may have dipped beneath the highs they’ve set in the previous two years, but they continue to rally. States continue to make progress in passing marijuana legislation and the federal government appears to be shifting, even slightly, toward a friendlier approach in issues of public policy, such as research, banking and taxation. This progress has had a positive impact on the Global Cannabis Stock Index in the past six months, raising it 71%.

With the legalization of recreational marijuana in California in January, the ensuing press coverage drew numbers of investors, new to marijuana stocks and investing in general. 

Though some cannabis companies show great potential for success and show continued improvement, a great deal of the marijuana stocks still trade on the OTC, and therefore, are not listed on the NYSE or NASDAQ. These stocks can often have significant limitations accessing capital, and if they generate any revenue, it’s not much. New investors are more vulnerable to the hype, stock promotion, or symbolic appeal of some of the sector’s worst companies, and fail to perform due diligence to the company’s business plan, management team, and financial status prior to making investments.

Among investor mistakes, this failure to thoroughly investigate a potential marijuana stock to invest in is the most glaring; however, there are others worthy of discussion, applicable to the marijuana sector and beyond.

One common mistake made among first-time investors looking for marijuana stocks to buy now is failing to diversify their portfolio.

Too often new investors, in general and in the cannabis stocks sector, make the mistake of choosing only one or two businesses to invest in. This is a risky strategy in the stock market at large, though especially so in the marijuana sector, where companies have little operating experience. Practically speaking, putting all your eggs in one basket is a far riskier move, making your potential loss that much larger should the stock suffer.

Say a stock suffers a loss of 50%, something that is not unusual among marijuana stocks; in order to break even, that stock must double its value. This is particularly challenging for the average cannabis stock, which is probably not generating much cash flow, and often resorts to convertible notes in order to fund existing operations. Unfortunately, this type of financing creates a downward pressure in the long run, owing to the nature of the debt being convertible, often at a discount, compared to the stock’s market price. The party holding the debt then sells the discounted stock, it re-enters the market, and a vicious cycle ensues that has the potential to wipe a company out.

First-time investors in marijuana stocks often end up in this position because of limited funds and trying to keep the total cost of commissions down.

However, it’s recommended that investors with at least $10,000 to work with purchase a minimum of 10 stocks. With online commissions around $5 per trade, the cost may be only 0.5% of an investor’s available funds.

It’s true that single stock investments can lead to big payoffs; however, not without huge risks. That said, should investors choose to take this risk of investing in only one or two stocks, they should do so with a clear understanding of the risks inherent in stocks, penny stocks in particular, and take care to avoid stocks that come with convertible debenture and no limit on the conversion price.

Another common mistake made by first-time investors in cannabis stocks is too much diversification. 

New investors are encouraged to diversify, but there is such a thing as too much portfolio diversification; the latter is less risky, but it still poses a risk. A too-large portfolio, especially if it consists of companies with the expectation of negative returns, will likely dilute rather than enhance one’s portfolio. In the cannabis sector in particular, there simply aren’t enough stocks to merit immediate investment. Therefore, a larger portfolio is bound to include plenty of duds.

The largest of mistakes among new investors in marijuana stocks is placing too much confidence in a company’s press releases. 

This relates back to the first and worst mistake made by any investor, failing to perform due diligence. Plenty of investors in cannabis stocks turn to press releases as a company’s primary information source, leaving out a far better option: a company’s filings. Investors can find these filings at www.OTCMarkets.com, or for securities listed in Canada, www.sedar.com.

In the U.S., companies can be categorized as either filing with the SEC or not, and the truth is, companies aren’t necessarily required to do so. However, investors should consider it a red flag if a company fails to file with the SEC, even though many of the sector’s stocks that are most actively traded (i.e., Medical Marijuana, Inc. and Hemp, Inc.) are among companies who have not once filed with the SEC.

While the nature of a company’s press releases tend to be bullish, their filings are often more balanced and revealing of a company’s pertinent information. Investors who read a company’s filings gain quarterly and annual access to the stock’s financial position, share structure, litigation, insider compensation and ownership, and any additional critical information not required in a press release. This strategy may be one of the best recommendations for investors to protect themselves from unforeseen and potential risks in the cannabis sector.

Bottom line: if an investor wonders how to invest in cannabis stocks, they should be careful with stocks that trade on the OTC. 

The marijuana sector tends to attract a number of opportunists. Taking serious consideration of the common mistakes listed in this article will help marijuana stock investors avoid greater risk and loss, as well as aid in being proactive and well-informed when deciding which marijuana stocks to invest in.

(For recommendations on diversification, read 5 Lesser Known Cannabis Stocks to Watch to Diversify Your Investments.)

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