If you’re going to buy penny stocks in gold, read this first

Gold is different from other commodities due to its scarcity, its special physical characteristics like freedom from tarnishing and malleability (the ability of a metal to be hammered into thin sheets), its unique suitability for use as a medium of exchange, and its place in the world’s financial history.

But keep in mind that no matter how appealing they look, you should limit gold stocks, like penny stocks in gold, to a modest part of your portfolio.

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Why we don’t recommend buying penny stocks in gold

Gold investing is a poor choice for most investors. For one thing, it involves a lot more guesswork than other aspects of investing.

The markets for widely traded goods like gold (as well as oil, foreign exchange, U.S. government bonds and so on) are inherently unpredictable. These markets are so big that there is no practical limit to how much you can trade in them. It follows that if you could predict them, you could wind up acquiring a measurable proportion of all the money in the world. Nobody ever does that.

One special risk to gold investing is that some investors take it to extremes. They invest too much capital, and some use options, futures or margin loans to gain leverage. This magnifies their losses when they are wrong on gold-price trends.

If you want to invest in gold, we think the best way to do so is to include some gold stocks in your stock portfolio. But don’t go overboard. Limit your gold exposure to a portion of the exposure you would otherwise devote to the resources sector of the economy.

The best gold stocks will generate positive cash flow even with low gold prices

Most gold firms’ shares will continue to be heavily influenced by the direction of gold prices. Meanwhile, though, the best gold stocks will generate positive cash flow even with low gold prices—and also offer rising production outlooks.

Some of the most highly promoted gold mining stocks are penny stocks which have yet to produce an ounce of gold. Many must still find gold, let alone add to their reserves, invest in mine feasibility studies, and raise a lot of money before they go into production. The prospects for most of these penny-mine properties, even though they may be in areas with production from existing mines nearby, are far from certain.

Instead, the best gold stocks have strong reserves, low production costs and are already producing gold. They also have a range of development projects, but their strong base of production cuts the risk of relying on new developments alone.

Furthermore, we look for well-financed gold stocks with no immediate need to sell shares at low prices, since that would dilute existing investors’ interests. The best junior golds have a major partner who has agreed to pay for the drilling or other exploration or development, in exchange for an interest in the property.

Remember, the best gold stocks all have strong balance sheets and low debt.

The longer you play, the likelier you are to lose from penny stocks in gold

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.

What to invest in instead of penny stocks in gold

We think it’s a mistake to build your portfolio in such a way that you have to do the impossible, such as predict the future direction of gold or any other commodity. You’re better off focusing on investments that can generate current income plus long-term capital gains. Three key choices for that kind of investing are stocks, bonds and real estate.

Stocks are a better choice. They are far more liquid than real estate, and are less vulnerable to a rise in interest rates. (A rise in interest rates would push up mortgage borrowing costs, which could cut into demand for real estate.) Stocks also provide much higher income than you get in bonds with current low interest rates. They are also less sensitive than bonds are to a rise in interest rates.

Have you stayed away from penny stocks in gold, or have you taken the risk in gold investing? Share your experience with us in the comments.