If you plan on making money with penny stocks, first realize that many are little more than very well executed marketing campaigns.

Buying penny stocks can lead to a big payday when you make the right choice. But the odds against success are high. Penny stocks are almost always involved in riskier ventures, such as finding mineral deposits that can be mined at a profit, commercializing unproven technologies or launching new software.

What’s more, it’s hard for any new company to grow into a profitable business, and it’s even harder in pioneering fields. But it’s relatively easy to launch a stock promotion that purports to have answers to social problems or ways to profit from emerging technology. That’s why penny-stock promotions are always more common than legitimate start-ups. Still, even legit start-ups often fail.

The risky appeal of the “ground floor”

Penny stocks have appeal for some aggressive investors who aim to get into fast-growing stocks at what they describe as “the ground floor.” They think the best way to profit in stocks is to buy them when they are just barely starting out on a growth phase that can last for years if not decades. Ideally, they want to buy the future top performers when they are still near or close to the penny stock range and have yet to be discovered by the broad mass of investors.

These investors rarely find what they’re looking for. That’s because there’s a large random element in investing, especially at the ground floor. Many promising junior stocks fail to thrive as businesses for one or more of any number of reasons. To borrow from the opening lines of Tolstoy’s Anna Karenina, successful stocks tend to have a lot in common, whereas unsuccessful stocks tend to suffer from their own unique sets of risks and faults.

Sometimes stocks with intriguing business concepts just never get anywhere. They generate a number of encouraging news releases, but these releases turn out to be a series of exaggerations and broken promises.

Promising stocks may start out with a brilliant idea or a plan to get involved in a high-profile or fast-growing business area. They may enjoy an initial burst of sales or even earnings. But many just can’t keep up the momentum. They never reach the critical mass they need to achieve consistent profitability.

This is more common in junior techs, because they compete with well-established, well-financed senior techs. The seniors have an enormous advantage in well-trained staff, sales networks, media contacts and all sorts of other business assets that can take years, if not decades, to develop.

You compound your risk if you invest in a promising junior that is a “thin” or illiquid trader. When a stock is a thin trader, it doesn’t take much buying or selling to influence its price. So if just one important investor decides to sell, it can cause an abrupt stock-price slump. This can spark a cascade of selling and a collapse in the stock’s price. The resulting stock downturn can scare off other potential investors. This can make it impossible for the formerly promising junior to raise additional funds when it needs them.

Investors in start-up companies also face one overriding, continual risk: it’s easier to launch a promising company than to create a successful business. That’s why only a minority of junior companies ever go on to significant success.

We consider penny stocks a gamble, but we do have some tips for making money with them if you decide to diversify your portfolio .

7 tips for making money with penny stocks

Penny stocks do sometimes pay off. There are many pitfalls to avoid. You should be aware that many penny-stocks are little more than very well executed marketing campaigns. Below are 7 tips that you can used when investing in penny stocks if you want to diversify your portfolio and avoid the biggest risks.

1. Look for well-financed companies: To profit in penny stocks, you should look for well-financed companies with no immediate need to sell shares at low prices, since that would dilute existing investors’ interests.
2. Look for a strong balance sheet: High-quality penny stocks should have strong balance sheets with low debt. It’s even better if they have a major partner who can finance the penny stock’s product to market or mine into production.
3. Look for strong management: Look for an experienced management team with a proven ability to develop and finance a mine, product or service.
4. Look for stocks trading on an exchange: We think you should avoid stocks trading “over-the-counter”, where such things as regulatory reporting are lax. Stick to penny-stocks trading in regulated exchanges like the Toronto and New York stock exchanges.
5. Look past the hype: We also recommend avoiding stocks that are trading at unsustainably high prices as a result of broker hype or investor mania.
6. Look for reasonable share prices: Compare the market caps (The total dollar value of all of a company’s outstanding shares) of the stocks with the estimated value of their assets or future earnings streams. Only a few penny-stocks will successfully launch a product with enough success to justify the current share price and avoid collapse.
7. Look for a focused company: Above all, you should automatically rule out investing in companies that promote themselves too aggressively, or do so misleadingly. Success is more likely if the managers focus on developing a saleable product or service, rather than hyping their story.

Have you been successful investing in penny stocks? Let us know in the comments.