In most years most stocks go up…the stock market is up.  Much of the time the stock market is not real interesting, with stock prices fluctuating moderately.  Most of the time we are in a bull market, where stocks go higher.  In a bear market prices fall.  When stock prices are crashing this is an exception that definitely gets the public’s attention.

This is especially true today, because millions of clueless investors have their financial futures riding on stocks (stock funds) in 401(k) and IRA plans.  Here’s your basic investor guide to bear markets of the recent past.  How bad have stock prices fallen before, and how does this compare to 2007-2009?

In measuring stock market or average stock performance, we will focus on the DOW JONES INDUSTRIAL AVERAGE (DJIA).  This stock indicator is the oldest and still the most popular with investors, often referred to as simply the DOW.  It tells you how the big blue-chip stocks are doing, and basically indicates how stocks in general are performing.

Historically, stocks have returned about 10% a year over the long term.  If the Dow drops 5% in a week, the vast majority of investors lose money.  When it drops by 20% or more over a period of time we are in a bear market, and virtually all stock investors (except the rare speculator) lose money.

History can give us a sense of perspective, and serve as a basic investor guide.  Now let’s look at some truly ugly stock markets.

The bear market that started in 1929 was the worst in American history, with the Dow falling 89% at its low in 1932.  It took about two decades for stock prices to then return to their previous highs of 1929.  A major reason for the market crash: excessive financial leverage.  Investors had bid up stock prices with borrowed money.

1973-1974:  In less than two years the stock market fell 45%.  This bear market was accompanied by rising interest rates and higher inflation.

2000-2002:  The Dow fell 38%, but growth stocks got hammered (especially hi-tech stocks).  The NASDAQ Composite Index fell 78% in less than three years.  Stocks that had gone up like a rocket fell to earth like a rock.  Investor speculation created excessive stock prices especially in areas related to personal computers, the internet and cell phones.

2007-2009:  After rising for about five years, stock prices started falling in the autumn of 2007.  A year later financial crisis acted as a catalyst and the market took a nose dive.  In early 2009 stock prices were down over 50%.  The world’s financial system, and economies across the globe, were in serious trouble.

Once again excessive financial leverage and speculation played a major role.  Major financial institutions,other corporations, investors and homeowners all participated in this game.  Financial leverage is simply investing with borrowed money.  Some major Wall Street firms went to incredulous extremes.  Some folks on Main Street did as well, speculating on real estate properties with little or no money down.

To sum it up, the bear market that started in late 2007 is the worst since the Great Depression.  The end can not be accurately predicted.  Investors generally focus about six months into the future.  When, and only when, they  see a brighter future they will start buying and send stock prices higher.  If the trend continues, a new bull market is born.

I heard a great story about Warren Buffett recently.  One day Warren was riding in the elevator at his office in Omaha.  A few other people got on the elevator as well.  In the middle of the floor was a shinny penny. Everyone had a chance to pick it up, but nobody did.  Finally after a few seconds Warren reaches down and picks it up.  He looked at it for a moment then slipped the penny into his pocket.

Rumor has it, he said “the start of my next billion” as he put the penny in his pocket.

I don’t know if the story’s true or not, but it sounds like something he would do.  We all have dreams of turning pennies into millions (or billions in Warren’s case).  Some people have a knack for making money out of almost anything.

In the stock market, there’s a high risk, high reward way to make lots of money.

 Investing in Penny Stocks.

Now before you question my sanity let me ask you a question?  Have you ever traded penny stocks?  Do you even know what a penny stock is?

There are hundreds of definitions for a penny stock.  Some investors think very literally.  Only stocks that trade for pennies a share are penny stocks.  The US Government defines penny stocks a little more liberally. Here’s the quote right from the SEC website:

The term “penny stock” generally refers to low-priced (below $5), speculative securities of very small companies.  While penny stocks generally are quoted over-the-counter, such as on the OTC Bulletin Board or in the Pink-Sheets, they may also trade on securities exchanges, including foreign securities exchanges.  In addition, penny stocks include the securities of certain private companies with no active trading market.

Look, forget all that legalese and government mumbo jumbo.

For me a penny stock is a publicly traded company whose entire market value (their market cap) is very small.  See, stocks are classified according to their size.  Large cap stocks are worth more than $50 billion.  Mid cap stocks are worth $10 to $50 billion.  Small cap stocks are worth $1 to $10 billion.  And micro-cap stocks or penny stocks are worth from $50 million to $1 billion.

How do you classify companies worth less than $50 million . . . I call them hobbies!

Seriously, if you’re able to invest heavily in one of these micro-cap penny stocks just as it starts to grow, you can make some serious money.

Do you want an example?

About a year ago I was doing some research on the coal industry.  If you don’t know, coal’s one of the biggest sources of energy for the United States.  Some people have even crowned it “King Coal” and called the US the Saudi Arabia of coal.

To say we have lots of the stuff is an understatement.

While I was doing some research I came across a very interesting company, James River Coal (JRCC).  The company was founded in 1988 and produces coal for sale to electric utilities and industrial consumers. They have 6 mining complexes, 26 underground and surface mines, and 10 preparation plants.  All told the company has more than 265 million tons of proven and probable coal reserves.

Not bad for a little company that in August of 2007 was selling for less than $5 a share.

James River Coal was a penny stock.  The entire company was worth less that $125 million dollars.

Coal prices however were starting to go up and up and up.  And do you know what went up and up and up along with prices?  That’s right, the stock prices of all the coal companies.  Not just James River Coal but some of the big players too.  Companies like Arch Coal (ACI) and Massey Energy (MEE) watched as their stock climbed.

So how can you make money trading these penny stocks?

The stock for JRCC was stuck below $5 for months and traded below $10 for almost half a year.  You could have bought all you wanted.

Then as oil prices and coal prices started to climb the stock just took off.  In less than a year the stock skyrocketed from penny stock status to more than $60 a share.  You read that right . . . more than $60 a share.

JRCC returned more than 1,100% in less than a year!

Now you’ll notice the stock’s recently fallen in price.  That’s no doubt due to many investors taking their huge profits off the table.  Despite this recent correction, the stock’s still up more than 500%.

Now you see how investing in penny stocks can be so valuable?

Don’t forget, like anything, investing in a penny stock does have some risk.  Make sure to do your due diligence and discuss with your broker all the risks and potential rewards of penny stock investing.

Penny stocks are very commonly seen as short-term investment rather than long-term investment stocks, because of their very volatile nature. Investing in a penny stock for a long-term might not be in your best interest because of the earlier mentioned volatility, which is why investors who venture into this territory understand that the nature of the market requires that they be ready to buy or sell at a moment’s notice.

In buying penny stocks there are factors that must be put into strong consideration such as, the financial stability of the company, business plan, and good trading volume. Also if you want to invest in penny stocks, you should be aware that there are lots of bogus newsletters that claim to give stock recommendations that work. In actual fact most of them will loose you more money than they can ever make you, but you will also find that there are few newsletters that deliver good results.

After you have done a proper research into the company stock you want to buy, your next task will be to decide what sort of investor you intend to be. Majority of people who invest in penny stocks are day traders and some short-term traders, but the bottom line is that many hold their stocks for few days to few months. However those who hold their stocks longer than one year have trading plans which they follow and you should not hold because others are holding.

If after due diligence you still think that penny stocks sound like your kind of investment, then your next line of action will be how to go about investing. You can buy penny stocks on the internet via an online stock broker that is registered (be careful what broker you choose to go with) and you can also buy through a broker that runs a brick and mortar business (broker’s firm).

Penny stocks can be a very good investment if you trade with care and get proper education on how to trade penny stocks.

Investing in penny stocks provides traders with the opportunity to dramatically increase their profits, however, it also provides an equal opportunity to lose your trading capital quickly. These 5 tips will help you lower the risk of one of the riskiest investment vehicles.

1. Penny Stocks are a penny for a reason.

While we all dream about investing in the next Microsoft or the next Home Depot, the truth is, the odds of you finding that once in a decade success story are slim. These companies are either starting out and purchased a shell company because it was cheaper than an IPO, or they simply do not have a business plan compelling enough to justify investment banker’s money for an IPO. This doesn’t make them a bad investment, but it should make you be realistic about the kind of company that you are investing in.

2. Trading Volumes

Look for a consistent high volume of shares being traded. Looking at the average volume can be misleading. If ABC trades 1 million shares today, and doesn’t trade for the rest of the week, the daily average will appear to be 200 000 shares. In order to get in and out at an acceptable rate of return, you need consistent volume. Also look at the number of trades per day. Is it 1 insider selling or buying? Liquidity should be the first thing to look at. If there is no volume, you will end up holding “dead money”, where the only way of selling shares is to dump at the bid, which will put more selling pressure, resulting in an even lower sell price.

3. Does the company know how to make a profit?

While its not unusual to see a start up company run at a loss, its important to look at why they are losing money. Is it manageable? Will they have to seek further financing (resulting in dilution of your shares) or will they have to seek a joint partnership that favors the other company?

If your company knows how to make a profit, the company can use that money to grow their business, which increases shareholder value. You have to do some research to find these companies, but when you do, you lower the risk of a loss of your capital, and increase the odds of a much higher return.

4. Have an entry and exit plan - and stick to it.

Penny stocks are volitile. They will quickly move up, and move down just as quickly. Remember, if you buy a stock at $0.10 and sell it at $0.12, that represents a 20% return on your investment. A 2 cent decline leaves you with a 20% loss. Many stocks trade in this range on a daily basis. If your investment capital is $10 000, a 20% loss is a $2000 loss. Do this 5 times and you’re out of money. Keep your stops close. If you get stopped out, move on to the next opportunity. The market is telling you something, and whether you want to admit it or not, its usually best to listen.

If your plan was to sell at $0.12 and it jumps to $0.13, either take the 30% gain, or better still, place your stop at $0.12. Lock in your profits while not capping the upside potential.

5. How did you find out about the stock?

Most people find out about penny stocks through a mailing list. There are many excellent penny stock newsletters, however, there are just as many who are pumping and dumping. They, along with insiders, will load up on shares, then begin to pump the company to unsuspecting newsletter subscribers. These subscribers buy while insiders are selling. Guess who wins here.

Not all newsletters are bad. Having worked in the industry for the last 8 years, I have seen my share of unscrupulous companies and promoters. Some are paid in shares, sometimes in restricted shares (an agreement whereby the shares cannot be sold for a predetermined period of time), others in cash.

How to spot the good companies from the bad? Simply subscribe, and track the investments. Was there a legitimate opportunity to make money? Do they have a track record of providing subscribers with great opportunities? You’ll start to notice quickly if you have subscribed to a good newsletter or not.

One other tip I would offer to you is not to invest more than 20% of your overall portfolio in penny stocks. You are investing to make money and preserve capital to fight another battle. If you put too much of your capital at risk, you increase the odds of losing your capital. If that 20% grows, you’ll have more than enough money to make a healthy rate of return. Penny stocks are risky to begin with, why put your money more at risk?