Be careful with hot penny stocks, which are often risky investments or overhyped marketing ploys

Only a minority of penny stocks ever go on to significant success. And while some hot 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.

Below we list some of the things to know and avoid while investing in penny stocks.

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Bad penny stocks require the most intensive marketing and promotion

Hot penny stocks do sometimes pay off, but there are many pitfalls to avoid. You should be aware that many penny stocks are little more than very well executed marketing campaigns. Penny stock promoters will do anything in their power to get their penny stock noticed. These extensive marketing campaigns include emails, TV interviews, podcasts, newsletters and paid sponsorships.

There are also some so-called news sites that will sell sponsorships to penny stock promoters. These are great opportunities for penny stock promoters but bad for investors looking for an unbiased opinion on a stock.

Major company involvement is frequently exaggerated with hot penny stocks

Penny stock promoters love to make deals—however minor or indirect—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 stocks can be riskier than other investments

Investors looking to add to the aggressive portion of their portfolios may turn to the higher-risk strategy of buying speculative penny stocks.

However, there are several potential risks when investors venture into hot penny stocks.

Buying low-quality 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.

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

Have you ever invested in hot penny stocks? How did it go for you? Share your story with us in the comments.