There are still lots of risks to be aware of, even with supposedly promising penny stocks

When you see a list of top penny stock picks online or elsewhere, you may be inclined to invest in one or more of them.

Buying promising penny stocks can pay off extremely well when it succeeds. But there are many pitfalls to avoid and the odds against business success are high. That’s because penny stocks are usually involved in riskier ventures, such as finding mineral deposits that can be mined at a profit, commercializing unproven technologies or launching new software. And while some penny stocks do take off, you should be aware that many penny stocks are little more than well-executed marketing campaigns.

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

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.

Big companies have more bargaining power than individual investors when it comes to promising penny stocks

It pays to remember that 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 property, program or gizmo, 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 outlay of $5 million—if this means it will get a chance to develop the one rare project that’s worth the investment of, say, $500 million. If it waits till the property, program or gizmo has proven itself, development rights will be much more costly. So it gets in early by investing what are, for it, token amounts of money. That’s why big-company involvement by itself is never a good reason to buy penny stocks.

Promising penny stocks are often involved with theme investing

Theme investing has a natural appeal. It simplifies things. Investors like it because they feel it can put their investment returns into overdrive. Some also feel it adds fringe benefits to their investing, by letting them support social or environmental objectives.

Brokers like it because it gives them a rationale to recommend a variety of stocks.

When you focus on theme investing, however, it’s easy to overlook the fundamentals. If you’re sure gold prices are headed up, for instance, why trouble yourself with tiresome matters like finances or geology? The same goes for solar power stocks, new battery technology developers and so on.

Of course, many investing themes carry a grain of economic sense. Government spending deficits and money-supply growth of recent years will eventually lead to a rise in inflation. But it takes more than a grain of economic sense to turn a company into a profitable investment.

Two keys to long-term success with promising penny stocks

You can put the odds in your favour by following two simple rules: Invest mainly in well-established companies, and spread your money across most, if not all, of the five main economic sectors (Manufacturing & Industry, Resources & Commodities, the Consumer sector, Finance and Utilities). You can do so directly, by selecting stocks from our recommendations in The Successful Investor, or by investing in funds that hold these types of stocks.

This puts time in your favour. The longer you stay invested, the more likely you are to come out ahead.

If you insist on buying promising penny stocks, pick penny stocks with money you can afford to lose. Ultimately, penny stocks should always be a small part of any diversified portfolio.

Be frank – what was the last penny stock you invested in that actually spun a profit?