Only a handful of penny stocks ever go on to significant success. Here’s how to improve your odds

It’s easier to launch a promising company than to create a successful business. That’s why only a minority of penny stocks ever go on to significant success. And while penny stocks can be a worthwhile addition to the aggressive portion of a diversified portfolio, you should in general only buy them with money you’re willing to lose.

Here are three key warning signs to watch out for to improve your chances of picking winning penny stocks.

Penny stock warning #1

Major company involvement is frequently exaggerated

Penny stock promoters love to make deals with major, household-name companies. They’re sure the public is far more likely to buy penny stocks that have agreements with large well-established clients. For example, a mining penny-stock may promote that Newmont Mining, BHP Billiton or another major mining company has decided to finance exploration of their mining claims.

However, when promoters manage to make a deal with a major firm, they often go to great lengths to make it seem bigger than it is. Instead of announcing that the big company has invested, say, $50,000, a stock promoter may issue a press release saying the two companies have entered into a “multi-stage development plan.”

The release may say the major company has agreed to spend “up to $10 million” or some other exalted figure. It will usually provide a toll- free number or web address for investors to order or download the glossy brochures.

Above all, remember that big companies have far more bargaining power than individual investors.

A big company doesn’t go into a situation like this the same way you do. If the big company agrees to spend $50,000 to study the mining property, new technology or pioneering program, it will also insist on a series of options that let it invest ever-larger sums on favourable terms. But the big company will always reserve the right to drop out and cut its losses. In most cases, it will exercise that right.

A major mining company will gladly spend $50,000 one hundred times, and lose every penny of it—a total investment of $5 million—if this means it will get a chance to develop the one rare project that’s ultimately worth an investment of, say, $500 million. If it waits until the property, technology or program has proven itself, development rights will be far more costly. So it gets in early by investing what are just token amounts of money for a major firm.

That’s why big-company involvement by itself is never a good reason to buy penny stocks.

Penny stock warning #2

Low-quality penny stocks are quick to fall when a bubble bursts

A decade or so ago, buyers of Internet startups made far more profit than investors who stuck with well-established companies. The same thing happened when many investors bought low-quality resource stocks in 2007 and 2008, and it has happened in the past in penny stock bubbles. However, when the bubble inevitably bursts, prices of low-quality stocks come crashing down.

Penny stock warning #3

The longer you play, the likelier you are to lose

If you lose money in speculative or other low-quality stocks (or ETFs 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.

That’s also why we think you should apply our sell-half rule.

Selling half your holdings after you double your earnings is a good strategy for any high-risk investment, but especially so for penny stocks.

This can give you a clearer perspective on what to do with the other half of your investment. After all, if you are too slow to sell speculative stuff, your profits and even your principal can evaporate all too quickly.

Have you identified how to pick penny stocks using any other indicators of failure? Let us know in the comments.