The most active penny stocks may be a quick way to lose your money

Some investors think the best way to profit with the most active penny stocks is to buy them when they are just barely starting out on a growth phase they hope will 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.

And it’s true that when you buy penny stocks you could have a big payday if you make the right choice. But the odds against success are high.

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The most active low-quality penny stocks may also be ones to avoid

Penny stock bubbles have helped investors profit, however, when the bubble bursts, prices of low-quality stocks inevitably come crashing down.

After all, it’s much easier to launch a stock promotion than it is to create a successful, lasting business.

Penny stocks tend to be more speculative, and are engaged in such things as finding mineral deposits that can be mined at a profit, commercializing an unproven technology or launching new software.

4 points of analysis we use when considering the most active penny stocks

• We want to see experienced management with a proven ability to develop and finance a mine.
• We look at environmental constraints where the junior mines are looking for minerals. In Europe and certain parts of the U.S., junior mines need a particularly rich find to justify the costs of overcoming environmentalists’ objections
• When we recommend junior mines that only explore for minerals, we prefer those that operate in an area with geology that is similar to that of nearby producing mines.
• We think you should avoid stocks trading over the counter, where such things as regulatory reporting are lax.

With the most active penny stocks, the longer you play, the likelier you are to lose

If you lose money in speculative or other low-quality stocks (or funds that invest in low-quality stocks), you may think your main mistake was bad timing. That’s a misconception. You can get lucky in penny stocks, just as in lotteries. But if you play long enough, the “house odds” eventually triumph over any run of luck. In penny stocks or games of chance, the odds are against you. So, time works against you. The longer or more often you play, the likelier you are to lose.

Use a bottom-up approach for better investing results

Using the bottom-up investing approach, you focus on understanding what’s going on, rather than trying to predict what happens next. You could call this descriptive finance. You delve into earnings, dividends, sales, balance sheet structure, competitive advantages and so on.

From there, it quickly becomes obvious that there’s an awful lot you don’t know about the risks associated with the investments you’re considering. So you try to design a portfolio in which the risks offset each other.

Using the top-down approach (which you might call predictive finance), you downplay what’s going on now and try to figure out what happens next. You may zero in on trends in stock prices, the economy, interest rates, gold and so on. You may disregard most details. Or, you may focus on a single key trend, event or detail

Over periods of five years and beyond top investment honours mostly go to a member of the bottom-up crowd. That’s partly because bottom-uppers tend to make fewer big mistakes. This lets their gains accumulate. This also leads to longer holding periods, which provide greater tax deferral and lower brokerage costs.

Two keys to long-term success

You can put the odds in your favour by following two simple rules: Invest mainly in well-established companies, and spread your money across most if not all of the five main economic sectors (Manufacturing & Industry, Resources & Commodities, the Consumer sector, Finance, and Utilities). You can do so directly, by selecting stocks from our recommendations in The Successful Investor, or by investing in funds that hold these types of stocks.

This puts time in your favour. The longer you stay invested, the more likely you are to come out ahead.

When you go to buy penny stocks, what type of pennies draw your interest the most? Share your thoughts with us in the comments.