Steer clear of speculative U.S. penny stocks and instead invest in blue chip stocks with a history of success to propel your portfolio toward long-term gains

In penny stocks the odds are against you. So, time works against you. The longer or more often you play, the likelier you are to lose. On the other hand, blue chip stocks are your best promise of investment quality—and of strong returns for years to come.

Ultimately, U.S. penny stocks should only be a small part of any diversified portfolio, if at all. And you should only buy the most speculative of them with money you can afford to lose.

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Beware of pump-and-dump schemes with U.S. penny stocks, or stock promotions in disguise

The operators of pump-and-dump schemes usually focus on small and little-known stocks with few if any tangible assets. Perpetrators already have a holding in the company’s stock. They plan to “pump” demand for their shares by circulating false, misleading or greatly exaggerated statements and predictions about the stock. Then they plan to “dump” their holdings after their hype has led to a rise in the stock’s price.

The stock usually collapses within a few weeks or months. Even though the practice of selling pump-and-dump stocks is illegal, successful prosecutions are rare.

A penny stock promotion is launched by penny stock promoters, usually by their marketing department or public relations firm. Penny stock promotions are created to make a penny stock appear more valuable than it actually is. That’s because 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 penny stocks to major household names because penny stock promoters have an easier time selling a penny stock when 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, and so on.

When they get any kind of deal with a major, penny stock promoters go to great lengths to make it seem bigger 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.

Follow these five tips to reduce the risk of investing in U.S. penny stocks

1. 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.
2. Avoid penny stocks that trade at unsustainably high prices because of broker hype or investor mania about the underlying commodity.
3. 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.
4. 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.
5. 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.

Buy high-quality blue chip stocks instead of speculative U.S. penny stocks to keep your portfolio stable

Many of the best “regular stocks” are blue chip stocks. Blue chip companies can give investors an additional measure of safety in volatile markets. And the best ones offer an attractive combination of moderate p/e’s (the ratio of a stock’s price per share to its per-share earnings), steady or rising dividend yields (annual dividend divided by the share price), and promising growth prospects.

Most successful stocks share these qualities in common:

• The most successful stocks come from successful companies.
• The most successful stocks maintain or increase their dividends.
• The most successful stocks have strong balance sheets, hidden assets, and experienced management teams.

On the other hand, some investors look to a penny stock as a quick way to boost their investment gains. While buying penny stocks can lead to a big payday, even when you make the right choice, the odds against your success are high. Penny stocks are almost always involved in riskier ventures. Even if you want to take on that risk, you need to be extra careful about the penny stocks you buy.

Bonus tip: Use our three-part Successful Investor approach to make strong stock picks

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.

Have you ever selected a penny stock over a proven blue chip stock? What informed you on making this investment decision?

Why do you think people continue to invest in penny stocks even though they are so risky?