There are several potential risks when investors buy penny stocks. Here are some of them.

Buying low-quality Canadian penny stocks is one of those things that can appear to be successful before it goes badly wrong. Some get hooked on it, since low-quality stocks can be highly profitable over short periods. That’s because they are generally more volatile than high-quality stocks.

The only ways to profit when you buy penny stocks

In general we avoid penny stocks that promote themselves too aggressively (or do so misleadingly). Here are some tips we consider when we analyze penny stocks for aggressive investors.

1. We want to see experienced management with a proven ability to develop and finance a company.
2. We look at environmental constraints when considering mining penny stocks in particular. When we recommend junior stocks exploring for minerals, we prefer those that operate in an area whose geology is similar to that of nearby producing mines.
3. We think you should avoid stocks that trade over the counter, where such things as regulatory reporting are lax.
4. We also like to see a sound balance sheet in all the penny stocks we recommend. We like to see enough cash to keep operations going without the need for dilutive share issues at low prices.
5. While you’re looking at the balance sheet you might also want to see if there are any hidden assets like real estate at historical prices.

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

A decade and a half ago, buyers of Internet start-ups 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. When the bubble bursts, however, 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 stock promoters sometimes aim to make companies appear bigger than they are

Penny stock promoters love to make deals (however tenuous) with major, household name companies. The link with a major gives them instant credibility, especially with investors who are willing to buy penny stocks.

When penny stock promoters get a deal with a major, they go to great lengths to make it seem bigger than it is.

In fact, when a penny stock shoots up on the news of big-company involvement, and the mineral property/unproven technology/revolutionary software is still in the early stages of development, it’s often a good time to sell.

The longer you invest in penny stocks, the likelier you are to lose

All penny stocks rely on luck to become wildly profitable. 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.

Buy penny stocks as a small portion of your portfolio, if 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. 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.

In general, penny stocks have lower trading volumes or liquidity, and this lack of liquidity means it may be more difficult to sell a stock when you want to. They also suffer from large price fluctuations, so any bit of news will cause a penny stock’s price to rise or fall.

Ultimately, Canadian penny stocks should always be a small part of any diversified portfolio. You should only buy them with money you can afford to lose.

Do you buy penny stocks? How has your experience been? Share your story with us in the comments.