The conclusive argument for buying penny shares

Bill Bonner has a friend who reckons that investing in the stock market is 'a crazy bargain'. 'The stock market is way over-rated,' according to this mystery pal, and people who think they will get rich by trusting in the stock market are 'dreaming.'

I could not disagree more. And if you stay with me to the end of this brief article I will give you my conclusive argument. I'll explain why the stock market not only beats return on cash and bonds over the long term but that it also does so by a wide margin. And just to drive the point home, I have some interesting gold plays for you too.

I'd like to start though by knocking off the points made by Mr Sceptic, one by one.

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Four reasons why Mr Sceptic is wrong

Point no.1: "When you buy a stock, you are buying a piece of a business that used to belong to somebody else. And he didn't want ithe's moving on to something better."

Well you could say the same thing about any transaction. For every buyer there has to be a seller, and the latter usually has a reason to sell other than a view that they will never get a better price. Just because people choose to sell works of art, for example, does not prevent their prices from rising.

What really seems to upset Mr Sceptic is the thought of buying shares off the company's founder. He hints that the founder must know things that outsiders do not. In this respect I agree. You should be careful if you see a company's founder, or its bosses, sell their shares. But this type of sale is rare.

Point no.2: Next, Mr Sceptic claims that buyers are getting shares in businesses that have "been puffed up by venture capitalists and initial public offering firms; embellished by stockbrokers and analysts and advertised by copywriters and salesmen".

Again this critique is not entirely without foundation, but it is applicable to the limited instances of initial public offerings that is, occasions when companies are sold to public shareholders for the first time. I would certainly caution against investing in new issues. Glencore was a classic example of a share that received maximum 'puff' and has quickly sunk below its initial offer price. But investors can buy shares without having to buy new issues.

Point no.3: "Investors are ready to believe anything", cautions Mr Sceptic. "In a bull marketeven the rubbish flies up in the air. But when the wind dies down you see that it is trash."

Again there is a grain of truth within this generalisation. There are two types of bull market. One has the firm foundations of profitable growth, while the second is based purely on an exciting new theme the dotcom boom being a classic example. The latter is dangerous and certainly some companies will be floated on the stock market in these periods that subsequently fail.

But while Mr Sceptic says that the "rubbish" will ultimately crash what he does not say is that the good stuff, those well managed companies that have a workable business model, will do well in a bull market and will not crash when it comes to an end. Mr Sceptic argues that the corporate growth upon which share prices depend is compromised by 'short termism' which again is probably true but only affects a small minority of companies.

Point no.4: Finally Mr Sceptic tackles the 'risk premium'. He gets in quite a twist over this, but what he seems to be saying is that if everybody thinks that it is worth taking the 'risk' of the stock market in order to get the 'premium' return then that extra return will be bid away until it is no longer on offer.

Frankly I have never taken any notice of the 'risk premium' or any other such theory dreamt up City strategists who have never bought a share in their life. Here's why.

My conclusive argument for buying penny shares

All independent long-term studies have shown that stock market investment beats the return on cash and bonds by a wide margin and that overall shares of small companies beat those of large ones. Mr Sceptic gives some useful, but highly selective advice. Don't get sucked in to bull markets inflated by hot air. Be wary of new issues. Look out for 'short termism.' Don't take too much notice of what brokers and analysts say about the companies that pay their bills.

But that still leaves you with plenty of established companies run with an eye to the long term, and shares that are not over-hyped.

Which brings me to my conclusive argument.

Last week I calculated the return on my wife's ISA portfolio, started twelve years ago. Every pound that she has contributed is now worth over £4. The annual rate of return is, I reckon, about 24%. That is persuasive enough for me. And it has one additional benefit. It makes my wife happy, and if she is happy, I'm happy (and I get to play golf).

An explosive opportunity in gold mining

One of the most exciting penny stories of this year has been in junior gold mining. I've already told you about my favourite gold stock a miner looking to develop a hugely promising gold resource in China.

And last week I read a fascinating report by MoneyWeek's resident gold expert, Dominic Frisby. Dominic has picked hisfive favourite gold miners to buy now. And I've been looking at a few of them myself over the last year. There are certainly some exciting prospects in the report. Put it this way, if you like exciting, high-risk penny stocks, you'll enjoy this report.

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