What are penny stocks and what are your odds for success with these risky investments? Test your knowledge with our latest quiz.

What are penny stocks and how do they fit into your portfolio? You should be aware that many penny stocks are little more than very well-executed marketing campaigns. Penny stock promoters will often do anything in their power to get their penny stock noticed. These extensive marketing campaigns may include emails, TV interviews, podcasts, newsletters and paid sponsorships.

While penny stocks do sometimes pay off, there are many pitfalls to avoid. Test your knowledge below with our quiz on penny stocks.

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• How do penny stocks rate in terms of risk and stability?

1.  Penny stocks typically have lower trading volumes and liquidity
2. Penny stocks have higher levels of price volatility
3. Penny stocks often trade on exchanges that lack regulatory oversight
4. All of the above

 You are correct if you answered 4.

Penny stocks can be more easily manipulated than most stocks that trade on exchanges. That’s because of their generally low trading levels and resulting price volatility. When you combine this with the lack of regulatory oversight on some stock exchanges and the fact that it is easy to launch these companies, you can see why investment fraud is more common with penny stocks.

•  What percentage of a conservative portfolio should be made of penny stocks?

1.  A small portion you’re willing to risk
2. 30% of your portfolio
3. 50% of your portfolio
4. None of the above

 You are correct if you answered 1.

Volatility is one reason why we recommend that penny stocks only make up a small portion of an overall investment portfolio, if any. And the most speculative of them are preferably bought with money that you’re willing to risk. In addition, penny stocks are best suited to investors who can accept substantial risk and can cope with the potential highs and the inevitable lows of risky investments in their portfolios.

Some investors think the best way to profit with the most active penny stocks is to buy them when they are just barely starting out on a growth phase that they hope will last for years if not decades. Ideally, they want to buy the future top performers when they are still near or close to the penny stock range and have yet to be discovered by the broad mass of investors.

However, if you’re wrong on a speculative stock, your losses are likely to be larger than any losses from your more-conservative selections. 

• Some of the biggest problems with penny stocks are…

1.  They are often very speculative
2. They are often low-quality investments
3. Penny stock prospects are often exaggerated
4. All of the above

You are correct if you answered 4.

 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. All penny stocks rely on luck to become wildly profitable.

What are penny stocks in regards to quality? 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.

Penny stock promoters love to make deals (however tenuous or indirect) with major, household-name companies. The link with a major gives them instant credibility, especially with investors who are willing to buy penny stocks. When penny stock promoters get a deal with a major, they usually go to great lengths to make it seem bigger than it is.

• The best penny stocks to invest in should have the following criteria…

1.  They should be a well-financed company
2. The firm should have strong management
3. Strong balance sheets
4. All of the above

You are correct if you answered 4.

To profit in penny stocks, look for well-financed companies with no immediate need to sell shares at low prices, since that would dilute existing investors’ interests.

Look for an experienced management team with a proven ability to develop and finance a mine, product or service.

High-quality penny stocks should have strong balance sheets with manageable debt. It’s even better if they have a major partner who can finance the penny stock’s product to market or mine into production.

• True or false: Do penny stocks most often increase the longer you hold them?

 You are correct if you answered “False.”

 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. Even with luck on the side of the penny stock investor, if they play long enough, the “house odds” eventually triumph over any run of good luck.

That’s also why we think you should consider applying 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.

Use our three-part Successful Investor approach to make better stock picks overall

• Hold mostly high-quality, dividend-paying stocks.
• Spread your money out across most if not all of the five main economic sectors: Manufacturing & Industry, Resources & Commodities, Consumer, Finance and Utilities.
• Downplay or stay out of stocks in the broker/media limelight.

What are penny stocks worth to you? Have you seen enough value to invest more than a small portion of your portfolio in them?

If most penny stocks are little more than a gamble, why do you think so many people invest in them?