Even though volatile penny stocks may attract aggressive investors, they are almost never worth investing in. That’s because they are way too speculative and more frequently than not will lead to higher levels of risk—and the loss of your money

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

Volatile penny stocks, and in particular those with little or no investment value, are less attractive than other pennies and should be avoided unless you are approaching them with money you can afford to lose.

Assessing volatile penny stocks and why stock beta ratings don’t work

Stock beta ratings are a commonly used measure of stock-market volatility.

Institutional investors are always looking for so-called “quantitative” measures like beta that can be automatically calculated by a computer program. Beta makes a broad statement about a stock’s history of volatility, but it doesn’t say much, if anything, about its prospects or investment appeal.

However, as a measure of risk, beta has a number of limitations. It is based on past data, so its use in predicting the future assumes the company being charted remains unchanged—in other words, no major acquisitions, divestitures or other company-altering events take place. In reality, a stock’s beta can rise or fall over a period of years or change abruptly.

To assess a company’s suitability for your portfolio, you are better off using more reliable measures of safety, such as steady earnings and cash flow, low debt and a secure hold on a growing market.

Volatile penny stocks are highly speculative

Investors looking to add to the aggressive portion of their portfolios may turn to the higher-risk strategy of buying speculative penny stocks.

However, there are several potential risks when investors venture into these penny stocks.

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.

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. Almost all penny stocks rely on luck to become wildly profitable. If you play long enough, the “house odds” eventually triumph over any run of luck.

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.

How to avoid buying volatile penny stocks for your portfolio

In general we avoid penny stocks that promote themselves too aggressively (or do so misleadingly). Here are some of the Successful Investor tips we consider when we analyze penny stocks for aggressive investors.

• We want to see experienced management with a proven ability to develop and finance a company.
• We look at environmental constraints when we consider mining penny stocks in particular. When we recommend junior stocks exploring for minerals, we prefer those that operate in an area whose geology is similar to that of nearby producing mines.
• We think you should avoid stocks that trade over the counter, where such things as regulatory reporting are lax.
• We also like to see a sound balance sheet in all the penny stocks we recommend. We like to see enough cash to keep operations going without the need for dilutive share issues at low prices.
• While you’re looking at the balance sheet you might also want to see if there are any hidden assets, such as real estate at historical prices.

Keep aggressive investment options like volatile penny stocks to a very small part of your portfolio

Our stock selections for aggressive investors tend to be more highly leveraged and more volatile than the conservative recommendations that form the core of our Successful Investor approach. Those aggressive selections can give you bigger gains, and bigger losses. This may be due to financial leverage, or to the risk in their industry or particular situation, or to upcoming changes we foresee in the level of that risk. Keep in mind that these or any aggressive investments should make up only part of most investor portfolios.

If you want to diversify your portfolio with aggressive stocks, you must first understand the chances you’ll take. They’re only suitable for investors who can accept substantial risk. You can be wrong on any of your stock picks, of course. But when you’re wrong on a speculative stock, losses are likely to be larger than with a well-established company that fits into our Successful Investor philosophy.

Zeroing in on a handful of small to medium sized companies can pay off nicely when it works, but it can be extremely costly when you pick too few winners and/or too many duds.

But that doesn’t mean you should avoid aggressive stocks altogether. We recommend limiting your aggressive holdings (assuming that these holdings represent sound investment value). This is because aggressive stocks expose you to a greater risk of loss.

What is your experience with penny stocks? Have you invested in any that paid off?