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Basics of Penny Mining Stock Speculation, Part 2

In an earlier article we discussed some basic principles for buying and selling low-priced junior mining shares. We looked at how knowing when to buy mining shares can often be determined by one's philosophy of gold and the gold market outlook. The topic of diversification was also discussed as well as knowing when to take profits.

In this article we'll look at some other aspects of investing in penny mining stocks, starting with what Robert Bishop has termed "penny pitfalls." In his book, "The Investor's Guide to Penny Mining Stocks," Bishop stresses the necessity of owning a diversified portfolio of penny mining shares. "Diversification," he points out, "spreads risk, thereby reducing them, and it also increases the odds of owning shares in a company whose shares skyrocket by 500 percent, 1,000 percent -- or more."

He adds, "Nobody knows what's going to be found underground until a property is drilled, and having several irons in the fire enhances the possibility that drilling results on at least one of a company's programs will be positive."

Taking the principle of diversification to the extreme, however, is one such "penny pitfall" that Bishop warns investors to avoid. Diversifying for the sake of diversification will not generate profits. A huge portfolio -- especially one that isn't tended carefully -- will tend to mask the winners and even crowd them out with an abundance of underperformers. A timely selection of fundamentally and technically sound mining shares is the key ingredient to success in the junior mining sector.

Another pitfall of overdiversification is that it tends to enrich one's broker at the investor's expense due to the higher commissions on smaller transactions, thus ensuring that investors never make a worthwhile profit. "Diversification is important," write Bishop, "but it shouldn't preclude making serious money -- not just the occasional big percentage gain that gets lost in the shuffle of a portfolio so large that it's almost impossible to follow anyway."

The flip side of the overdiversification coin is that too often investors don't own enough of the biggest winners in their portfolio. Bishop emphasizes that they should own stocks in a disproportionate amount based on their experience in the market and on their expectations for individual stocks. This is done to avoid being in the position of making huge gains in percentage points and only a negligible amount of money. "Investors who really like a stock...should also own more of it, not relegate it to a position of equality in a portfolio," he says.

Bishop concludes by stating, "Gold mining remains a speculative activity, but it's not the flagrant crap shoot it used to be. Barring a collapse of gold prices, choosing stocks with care and employing a contrary strategy to time purchases should produce profits much more often than losses."

Equally important in our discussion of penny mining investing is the practice of good portfolio management. In his excellent book, "Making Dollars With Pennies (How the Small Investor Can Beat the Wizards on Wall Street)," author Max Bowser lists three basic rules for managing a well-selected penny stock portfolio. The first is quantity, i.e., how much of a given stock should the investor purchase.

Says Bowser, "Initially, you should take a small position in [a penny stock]. They do bounce around. Maybe they spike up for a transitory reason. Another newsletter or a brokerage firm recommends one of them. This is an artificial stimulus.

"After a while they will settle back. You don't want to buy when they have spiked up. Improving performance is the only engine that drives up a stock price and keeps it up."

The second factor the investor needs to consider in portfolio management is time. As Bowser observes, time can be your best friend or your worst enemy. He points out that the liquidity of stocks in general (compared with other markets) often encourages investors to embrace a short-term view. "In fact," writes Bowser, "no other investment form has the liquidity of stocks. Because of this, many equity investors have unrealistic expectations. They want sensational results quickly. If a stock doesn't double in a year or two, they are ready to throw in the towel. They ignore the fact that it takes time for a company to develop."

The lesson to be learned here is that above all, it requires patience to be a successful investor in the junior mining sector.

The third and final factor that Bowser relates to the successful speculation in penny stocks is that of discipline. "The chief advantage of having the discipline to follow a game plan is that it removes emotions from your decision making," he writes. "Especially in the critical area of selling. Which, in many cases, determines the success or failure of a portfolio."

For example, if a stock in your portfolio doubles and you sell half your position, you might be tempted to buy more shares on the next pullback of 25% to 35% from its previous high. But with penny stocks this is often not a wise thing to do since such sharp retracements are often the beginning of a decline and not merely a temporary pullback. Buying on the dips is a strategy that is usually best left to the larger cap stocks. As Bowser says, don't let "Mr. Greed" influence your emotions when investing in penny stocks.

In the third installment in this series on penny mining stock investing we'll look at the requirements of a mining company's balance sheet before it becomes a buy candidate. We'll also discuss the fundamentals of picking winning penny stocks.

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