Turn Pennies Into a $1M Portfolio

The title of this article appeared in my inbox the other day. My first thought was "How did this slip past my spam filter?" But that was quickly shoved aside in favor of, "I have pennies, how do I turn them into a $1M portfolio?"

The answer? Drum roll please ... trade penny stocks!

If that makes you a bit skeptical, then you're not alone. And my skepticism only grew when I saw a chart similar to the one below illustrating how this penny stock program could make you rich.

Now that may not have started with pennies, but the result is impressive nonetheless. And while pulling off 10 straight trades gaining 75% may seem far-fetched, the owners of the website seem to think it's a reasonable expectation considering the (supposed) average return of the service's picks is 75%.

Of course the service could have racked up that pick average of 75% by nabbing one amazing 1,200% rocket shot and nine 50% losses. That would have left an investor's $500 initial stake at a piddling $12.70. Or the service could deliver eight amazing picks with returns above 100%, but mix in just a couple 99% losers. Once again, that's the same 75% average, but it would leave investors with just $26.

The website in question is riddled with plenty of other aspects that don't pass the smell test -- like the fact that two examples of "successful" trades are based on the stocks of bankrupt companies -- but the numbers above illustrate a very important point. It's actually Warren Buffett's No. 1 rule of investing.

Do you know what it is?

Don't lose money
We can always count on the archive of quotable Warren Buffett to provide us with easy-to-say and not-always-easy-to-do advice, but this one is particularly important. Simple math tells us that as losses mount, it becomes increasingly difficult to get back to even. A 10% loss only takes an 11% gain to recover, but a 33% loss requires a 52% gain and a 50% loss needs a double to rebound. To get back to even after a 90% loss, you need a 900% screamer.

While the huge gains that appear possible in penny stocks may look exciting, the volatility and unpredictability of that wacky group makes it all the more likely that you'll stumble on some big losers. And sometimes all it takes is one massive flop to land your portfolio in the ICU.

Beat the penny-stock blues
As I noted above, two of the successful trades that the website highlighted were stocks of companies that were already bankrupt. That's lunacy. Trading stocks like that is simply hoping that there's somebody else out there dumber -- or at least greedier and with worse timing -- than you who will be willing to buy those shares at a higher price.

Taking big swings at absurd stocks like that practically guarantees that you're going to run afoul of Buffett's first rule. So how about we try a better plan, focusing on:

1. Investing in established, successful, profitable companies
2. Diversifying
3. Looking for reasonable valuations
4. Demanding dividends

The market may not be as cheap as it was during the depths of the financial crisis, and the sickly economy is still giving some companies fits, but there are still plenty of stocks out there that we can use to fill out a portfolio that fits the bill.

Source: Capital IQ, a Standard & Poor's company.

These stocks may not have the pizzazz of wild penny stocks, but the point is to build long-term wealth, not use the stock market to feed our inner gambler. And if you really need to do the latter, I'd recommend horse racing -- watching horses fly around a racetrack is much more exciting than watching a stock chart.

As for the group above, I think this could be a darn good start to a solid portfolio. To start with, these companies are anything but fly-by-night operations -- and, as if it bears reiterating, none of them are bankrupt or anywhere near. Altria, for example, we all know as the company behind the world's most popular cigarette brand, United Technologies is the industrial giant that supplies the world with elevators and escalators (among other things), and ConocoPhillips is one of the titans of Big Oil.

All of these stocks are also trading at what seem to be very attractive prices. The earnings yield -- that is, earnings per share over share price -- for the priciest of the stocks above is 7%, which, according to my math is a speck better than the 2.7% 10-year Treasury yield.

Sure, there are "reasons" behind some of the low valuations. Baxter, for instance, was shellacked earlier this year when it dialed back its full-year forecast. And Intel has watched its stock slip in recent weeks as investors became concerned that a shaky economy would hit the PC market -- a fear that was confirmed last week when the company lowered its outlook. But current valuations seem to overcompensate for the concerns.

Finally, all of these companies sport a good dividend yield. If you ask me, this can be one of the best signs that a company is stable, reasonably priced, and on the same page as shareholders. Slower growers of the group like Altria and Exelon offer the fatter current yields, but don't underestimate what faster dividend growth can do for companies like United Technologies and Intel.

But whether you agree with me on the specific stocks above, the point here is that there's nothing wrong with a little gambling from time to time -- at least, I don't think there is -- but your investment portfolio isn't the place to do it. Do your own research, invest in real companies, and leave the penny stocks for folks who don't care about retiring.

You may not be able to short most lousy penny stocks, but there are other lousy companies lurking out there begging to be shorted.