Avoid costly mistakes in penny stock and venture capital investments by navigating speculation booms

In the 1990s and early 2000s, many Internet stocks rose to extraordinary heights based on the number of visits to their websites, rather than dollars in their bank accounts. Back then, lots of analysts and investors believed that these stocks could go on rising indefinitely. Instead, the Internet stock boom ended suddenly, like almost every speculation boom does. Most of the top Internet stocks collapsed and brought huge losses to investors.

Investors need to be wary when the signs of a speculation boom appear, especially in both venture capital and penny stocks.

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Venture capital investing is subject to a speculation boom

We rule out some investment areas regularly when we feel they offer bad odds of making a gain. For example, venture capital investing is always highly volatile. What’s more, high management and other fees tend to offset lots of gains in good years, and eat up a lot of your capital in bad ones.

Now is a particularly bad time for individual investors to delve into venture capital. That’s because a number of highly innovative technology investments have done remarkably well, and this has helped spark an enormous boom in the field. Money has been flooding into venture capital investments in recent years. In speculation boom, a flood of money tends to bid up the prices of all opportunities, good and bad.

Note, however, that many of today’s venture-capital success stories have yet to reach profitability. They are taking in ever-larger amounts of money from outside investors, and expanding their revenues by using these incoming funds to finance negative cash flow.

Even the most promising opportunities can fail to make the transition from exciting start-up to self-sustaining, profitable company.

You run into the same problem in venture capital investing as in penny-stock investing: It’s easier to launch a venture-capital deal or a stock promotion than it is to create a profitable business.

If you profit during a speculation boom, consider the “sell-half” rule for your speculative stocks

Selling half of hot stocks that surge helps you guard your profits. But apply this rule only to more aggressive stocks, and not to the well-established stocks that may surprise you by going a lot higher in the long run.

Knowing when to sell a stock is one of the most important factors in successful investing—it’s almost as important as knowing when not to sell. That’s why we advise investors to follow a key rule when it comes to rising stocks.

Whether your approach to investing is conservative or aggressive, the quality of your investments matters much more than your skill at selling.

However, you should be quicker to sell aggressive stocks than conservative ones. With stocks we rate as “Speculative” or “Start-up,” it pays to apply our sell-half rule. That’s when you sell half of a stock that doubles in price.

Avoid investing in a speculation boom by using our three-part Successful Investor philosophy

1. Invest mainly in well-established, dividend-paying companies. Ideally, some of your picks should also have hidden assets. That is, assets that many investors disregard or fail to appreciate.
2. Spread your money out across most if not all of the five main economic sectors: Manufacturing & Industry, Resources & Commodities, the Consumer sector, Finance, and Utilities.
3. Downplay or avoid stocks in the broker/media limelight, where a modest business setback can set off a deep, sudden and sometimes permanent drop in the stock.

Bonus Tip: Be wary of stock warrants

A warrant gives its holder the right to buy a security at a set price for a specified time.

Warrants are frequently given as a “sweetener” along with new stock issues to persuade investors to buy them.

Stock warrants are very similar to stock options but they differ in a couple of ways: Warrant issues are granted by the underlying company itself; and the longest term for an option is typically 2 to 3 years, while warrants can have an expiration of up to 15 years.

Unlike common shares, though, warrants have built-in drawbacks that add considerable risk. These include:

• Limited room for error. Because a warrant has a fixed life, it loses some of that time value every day (that’s why it is considered a “wasting asset.”).
• Risk of total loss. Stocks can, and do, become worthless. But a warrant holder runs a much greater risk of losing the entire amount paid for the option in a relatively short period. This risk reflects the nature of an option as a wasting asset, which becomes worthless if it expires without being exercised.
• No ownership rights. While stock ownership provides the holder with a share of the company, voting rights and rights to dividends (if any), warrant owners participate only in the potential benefit of the stock’s price movement.

To profit in warrants, you have to be right about three different factors. Your warrants have to go up (rather than sideways or down) within their fixed life, and by a large enough factor to offset what you paid for their time value. That’s why it’s so much harder to make money in warrants than in stocks.

In the past, how have you avoided giving in to a speculation boom?