At a party recently I told a friend that I wrote articles about penny stocks. He replied that he preferred to stick with "safe" investments. When I asked what he meant, he said, "you know, bigger stocks like Microsoft, Amgen, and GE. Most of the time I'll just buy a mutual fund."

To be polite I didn't laugh about it until I came home to sit down and write this.

Penny stock investments might be volatile, but the risks of these investments are greatly exaggerated in some investor's minds. Sadly, the risks inherent in large cap stocks and money management tools are as often ignored by investors. I think it's only prudent when making portfolio decisions to evaluate risks carefully before investing. Let's do that here.

Volatility

Penny stocks are more volatile on a daily basis than large cap stocks. Because these issues trade at low price points and speculators jump in and out, some think this volatility is damaging.

On the contrary, volatility is a penny stock investor's friend. People learn to play the bounces of penny stocks to quickly build a portfolio value.

Why do investors think of volatility as evil? In the large cap market, volatility often means the stock is moving for reasons beyond the individual's control. Government data appears and the entire market heads south. If a stock beats the Dow Jones Industrial Average by a few points it's a great day for investors. Because of this, large cap investors fear volatility.

Penny stocks often don't react to large market news. On bad days it's not hard for penny stocks to make money. A penny stock trader will tell you that they'll take speculators and uncertain data any day over government data and stocks that follow the broad market most sessions.

Fundamentals

Good penny stock investors becomes comfortable with some warts on the balance sheet. Great penny stock investors can discern which fundamentals are just cosmetic and those that are potentially fatal. Large cap stocks aren't well researched by many investors before they throw money at a stock, and many may be dangerous. Delphi was recommended by an analyst three days before they went bankrupt! Enron continually told investors everything was okay and there was no need to panic. K Mart and General Motors were both considered "institutions" that couldn't fail before heading into bankruptcy court.

The bottom line is that fundamental analysis is important no matter what size stock you decide to trade. The difference between penny stocks and large cap stocks is that the volatility of penny stock markets creates opportunities for someone willing to spend time on research to make exponentially more money than they can in large cap stocks.

Inflation Risk

Ask any financial planner what their biggest fear is about their client's portfolio, and the word "inflation" will come up in the top three answers. Why? Many investors don't realize the huge threat to their nest egg that inflation presents. If an investor wants to invest only in "safe" investments that keep pace with inflation, how much money will they have for retirement? It isn't difficult to understand that if you never beat inflation you'll need to save nearly dollar-for-dollar what you're going to spend in retirement. How easy is it going to be to accumulate any real money when your investments are all in "safe" places?

Clearly, unless you're saving half your income to live on later, you'll need a strategy to beat inflation. In good markets large cap stocks might help, but what about years like 2000 to 2010? If these types of years continue in large cap markets it spells doom for many investor's retirement plans. Investors need to look for some place to trade where they can systematically improve a portfolio enough to make a difference. That's where penny stocks excel. Investors in this arena have the ability to easily outpace inflation and save enough to retire in the manner they choose.

Fees

The great news about mutual funds is that someone is getting rich. Sadly, it's probably not you. As a former financial advisor, it became difficult after a few years to justify the huge expenses that everyone between an investor and the investment was skimming off the top. Here's how it worked: the fund would have a management expense ratio. Although some funds have fairly low levels, many charged over 1.5 percent of the value of the account. Funds hid trading costs by reporting gains to the fund after traders were paid. These are often up to .5 percent or higher. As an advisor, we'd take 2 percent of the value of the portfolio.

What do all of these percentages mean? They mean that the client had to make four percent just to pay everyone helping them, even on days they lost money! Many people think that funds only take fees from profits. Sadly, fund managers are going to get paid their four percent regardless of results. Like a leach, their job is to keep you earning just enough that you'll give them another quarter to sit on your money and collect high fees.

Penny stock investors have one fee: trading costs. These are an up-front cost that the investor sees every time they make a move and can evaluate before deciding whether a trade makes sense or not. Because there is a much tighter lid on fees, penny stock investors can invest confidently without constantly finding out who has their hand in the cookie jar.

Before calling penny stocks "too risky" for your portfolio, remember that your goal, whatever it may be, is going to require funding. If you're worried about investment fees, bankruptcy, inflation, and volatility, you may want to look more closely at your portfolio. It may be time for penny stocks to help spread the risk and create better returns.