Investors often ask us, “Is investing in penny stocks a good idea?” We think there are ways to invest in penny stocks, but it needs to be done with a lot of caution.

Is investing in penny stocks a good idea? Well, it’s possible to make money from penny stocks, but only if you follow tips like ours below—and utilize our Successful Investor approach for the bulk of your portfolio.

Ultimately, penny stocks could make up a small part of any diversified portfolio. And, you should only buy the most speculative of them with money you can afford to lose.

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Is investing in penny stocks a good idea? Use our “sell-half” rule with penny stocks to boost your profits over time

Knowing when to sell a stock is one of the most-important factors in successful investing—it’s almost as important as knowing when not to sell. That’s why we advise investors to follow a key rule when it comes to rising penny stocks.

Selling half of your hot stocks that surge helps you guard your profits. But apply this rule only to more aggressive stocks, and not to the well-established stocks that may surprise you by going a lot higher in the long run.

Whether your approach to investing is conservative or aggressive, the quality of your investments matters much more than your skill at selling.

However, you should be quicker to sell aggressive stocks than conservative ones. With stocks we rate as “Speculative” or “Start-up,” it pays to apply the sell-half rule.

Is investing in penny stocks a good idea? Follow these five tips to cut the risk of investing in penny stocks

• Apply our sell-half rule. Selling half your holdings after you double your investment 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.
• Avoid penny stocks that trade at unsustainably high prices because of broker hype or investor mania about the underlying commodity.
• Look for earnings or cash flow. A perpetual money loser will eventually go broke, no matter how impressive its technology. But if it makes even a little money, it can stay in business and perhaps reap the bonanza of a new product.
• Watch out for acquisitions. Acquisitions can bring “time-bomb” risk. Companies sometimes grow quickly by buying other companies. But it may also be the case that those selling the companies may simply want to bail out of a losing situation.
• Spread your penny stocks out across different market segments. When making a list of penny stocks, we recommend investing in a range of markets. This includes software, biotech, technology, mineral exploration and so on.

Is investing in penny stocks a good idea? Well, the odds are against you

To assess a company’s suitability for your portfolio, you typically start by looking at measures of safety, such as steady earnings and cash flow, low debt and a secure hold on a growing market.

Meanwhile, 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 these 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.

If you lose money in speculative pennies or other low-quality stocks, you may think your main mistake was bad timing. That’s a misconception. Almost 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, as with 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.

Is investing in penny stocks a good idea? Only if you are using money you can afford to lose to buy the most speculative of those stocks. Overall, use our three-part Successful Investor approach to make better investments  

1. Invest mainly in well-established, mostly dividend-paying companies;
2. Spread your money out across most if not all of the five main economic sectors (Manufacturing & Industry; Resources & Commodities; Consumer; Finance; Utilities);
3. Downplay or avoid stocks in the broker/media limelight.

Bonus tip: We don’t think stock beta ratings are very useful

Stock beta ratings are a commonly used measure of stock-market volatility.

Institutional investors are always looking for so-called “quantitative” measures like beta that can be automatically calculated by a computer program. Beta makes a broad statement about a stock’s history of volatility, but it doesn’t say much, if anything, about its prospects or investment appeal.

However, as a measure of risk, beta has a number of limitations. It is based on past data, so its use in predicting the future assumes the company being charted remains unchanged—in other words, no major acquisitions, divestitures or other company-altering events take place. In reality, a stock’s beta can rise or fall over a period of years or change abruptly. 

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