Although some investors are intrigued by the prospects of penny stocks, it’s important to be wary of penny stock frauds and scams that can cost you money

Penny stocks can be more easily manipulated than most stocks that trade on exchanges, mainly because of their generally low trading levels and resulting price volatility. Combine this with a lack of regulatory oversight on some stock exchanges, and the fact that these companies are easy to launch, and you can appreciate why investment frauds are more common with penny stocks.

Penny stock frauds and scams do happen and it is important to recognize how to spot them.

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Penny stock frauds and scams may look like this

A penny stock promotion is launched by penny stock promoters, usually by their marketing department or public relations firm. Many penny stock promotions are created to make a penny stock appear more valuable than it actually is. And the key takeaway for investors: it’s much easier to launch a penny stock promotion than it is to create a successful, lasting business.

Penny stock promotions often try and tie a penny stock to deals with major household names—however small or indirect. That’s because penny stock promoters have an easier time selling a penny stock when, say, a major mining company has agreed to look at their mining claims, or if a household-name multinational has agreed to evaluate their revolutionary software or “cloud” application.

When they get any kind of deal with a major company, penny stock promoters go to great lengths to make it seem more important than it is. In fact, when a penny stock shoots up on the news of big-company involvement, and the property/program/revolutionary software is still in the early stages of development, it’s often a good time to sell.

Some penny stock promoters are just doing their jobs, maybe even reporting the facts as they see them, but some are out to make money at any cost. The goal for savvy investors is to spot a penny stock promotion for what it is and when to know a company has actual growth potential.

Penny stock frauds and scams are easier to fall for when combined with online trading

The main risks of online trading come from the fact that it all may seem deceptively easy. The lower costs and higher speeds of online trading can lead otherwise conservative investors to trade too frequently or even dabble in penny stocks.

It may even tempt some investors who trade stocks online to use automated stock-picking systems to help them make investment decisions. These systems are typically marketed with impressive-looking performance records designed to make investors think they are sure to make guaranteed profits. However, those records are typically derived by “back-testing” the program against past data. In other words, the promoters go back through old trading records and see what would have worked in the past. That’s far from a guarantee of what will happen in the future, though.

Four penny stock negatives every investor should know

1. The least promising penny stocks require the most intensive marketing and promotion
2. Penny stocks can be much riskier than other investments
3. Penny stock promoters sometimes aim to make companies appear bigger than they are
4. Major company involvement is frequently exaggerated with penny stocks

Avoid penny stock frauds and scams by analyzing your penny stocks with these six key points in mind

1. Avoid Canadian penny stocks that trade at unsustainably high prices. Instead, look for reasonable share prices in relation to future profits.
2. Buy multi-product companies. Technological advances come in spurts, and they tend to leapfrog each other. Focus on tech penny stocks that have some existing or soon-to-be-released products, and avoid one-hit wonders.
3. Focus on up-and-coming technologies. To do this, you need to know how technology is changing. For instance, the immense popularity of wireless devices, like the iPhone and tablet computers, stepped up demand for faster, more reliable wireless networks.
4. Look out for acquisitions. Acquisitions can bring “time-bomb” risks. 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.
5. Only buy the most speculative penny stocks with money you can afford to lose. Ultimately, penny stocks should always be a small part of any diversified portfolio.
6. Spread your penny stocks out across different market segments. When making a list of penny stocks to buy, we recommend investing in a range of markets. This includes software, biotech, technology, mineral exploration and so on.

Above all, stick to our three-part Successful Investor strategy for your overall portfolio:

1. Invest mainly in well-established 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.

The third element in our strategy is key to avoiding penny stock frauds and scams. These penny stock promoters focus on companies that would likely to go nowhere but for their connection to some trend or industry development that is getting a lot of media attention. It takes a lot more than that to create a profitable business or investment. But if you let the media hoopla taint your investment decisions, you increase your risk of blundering into an overly  promotional stock.

Have you been able to invest in penny stocks while avoiding frauds and scams?

Do you think penny stock scams are very common? Or do you just find them easy to avoid?