Understanding the difference between penny stocks and blue chip stocks will help you pick the best investments for your portfolio. Learn all about it now.

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.

Knowing the difference between penny stocks and blue chip stocks is important for your portfolio returns.

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Understanding the difference between penny stocks and blue chip stocks: Penny stocks are highly speculative, while blue chips have proven track records

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. 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 for the investor.

Still, investors looking to add to the aggressive portion of their portfolios may turn to the strategy of buying speculative penny stocks.

They should note, however, that there are several potential risks when investors venture into 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.

On the other hand, 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.

Understand that there is a big difference between penny stocks and blue chip stocks over time

Penny stocks: Although the price may seem right, the average penny offers a poor long-term return. After all, it’s hard to create a successful business. It’s much easier and cheaper to set up a company and sell stock to the public. That’s why bad penny stocks always outnumber good ones.

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

Blue chip stocks: The blue-chip investments we recommend have a history of profits going back for at least 5 to 10 years. Companies that make money regularly are safer than chronic or even occasional money losers.

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 to its per-share earnings), steady or rising dividend yields (annual dividend divided by the share price) and promising growth prospects.

Know the difference between penny stocks and blue-chip stocks to protect your portfolio from loss

We feel most investors should hold the largest part of their investment portfolios in securities from blue chip companies. All these stocks should offer good “value,” that is, they should trade at reasonable multiples of earnings, cash flow, book value and so on. Ideally, they should also have above average-growth prospects in expanding markets.

In general, on the other hand, penny stocks have lower trading volumes or liquidity, and this lack of liquidity means it may be more difficult to sell a stock when you want to. They also suffer from large price fluctuations, so any bit of news will cause a penny stock’s price to rise or fall.

We think you should apply our sell-half rule with pennies. Selling half your holdings after the stock doubles 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.

Ultimately, penny stocks should be limited to a small part of any diversified portfolio. You should only buy the most speculative of them with money you can afford to lose. 

Use our three-part Successful Investor approach for better investment results 

1. Invest mainly in well-established, 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.

What would persuade you to buy penny stocks over blue chip stocks? 

Have you been tempted to buy penny stocks? What made you choose them?