Ready to Buy Your First Stock? Steer Clear of These.
We recently suggested where to look when you are ready to buy your first stock. While you have a good idea of what to look for when getting started with investing in stocks, it is just as important to know what to avoid. Some stocks are destined to fall in value. Others are very high risk and more of a gamble than an investment — and first-time investors should do their best to avoid gambles, especially if they’ve got limited funds to invest.
Do your best to avoid these types of stocks, especially if you’re just starting out.
“Penny stocks” is a term used to describe stocks with a share price below one dollar per share. Sometimes these are high-quality companies that hit tough times, but more often than not the low share price is due to the company’s high risk and low market value.
In fact, if a company’s 30-day average share price falls below one dollar, it is kicked off the New York Stock Exchange and forced to an over-the-counter exchange, sometimes called the Pink Sheets, where companies that don’t meet listing requirements go to trade off of the major exchange. Trading outside of a major exchange means less trading volume and more risk, so new investors should avoid this category of stocks.
Penny stocks may look attractive because you can buy a lot of shares at a low cost per share. It feels better owning 2,000 shares of a company than just one of another. However, I would happily take one share of Google’s parent company Alphabet, currently valued at $972 per share, over 2,000 shares of a penny stock trading at 50 cents per share any day. While the market values are similar, odds are Google is going up in the long-run while the future of the penny stock is anyone’s guess.
The stocks of large, established companies are known as Blue Chip stocks, signifying their low risk. These companies tend to have stable stock prices that move with the market. Newer, more volatile, and high-risk companies have bigger swings in stock price. One of the most popular methods to measure risk is beta, where the overall market has a beta value of 1.0 and higher numbers are considered riskier.
Other companies carry risk due to their business operations. For example, many small pharmaceutical companies hinge their future on one blockbuster drug. An FDA approval might send the stock to a new high, but the drug may also encounter obstacles, setbacks, or an FDA rejection, which could bankrupt the company and send the stock to zero. You probably don’t want to risk your investment dollars on an FDA decision, and most new investors should avoid similarly risky companies. This doesn’t mean all pharmaceutical stocks are high risk, but this industry tends to have a concentration of risky stocks.
Herbalife is one of the most controversial stocks on the market today. Why? Activist investor Bill Ackman, head of Pershing Square Capital Management, is a well-known investor who has bet heavily against Herbalife, a multilevel marketing company (MLM) with its own controversial sales methods. Despite some recent stock price success, Ackman has held a short trade on the company for more than four years, or a bet the stock price will go down. While Ackman certainly doesn’t have a perfect record, the risk surrounding this company is likely too much for small investors to handle.
Other stocks that attract controversy are good to avoid as well. If you see a company with too much negative news, or a history of boom-and-bust price cycles, do your portfolio a favor and look to the next stock on your list.
Start With Safe Investments
Penny stocks, high risk stocks, and controversial stocks all have something in common: above-average risk that your investment will go down in value. Typically stocks with higher risk can lead to higher returns, but that type of risk is best held for investors who have some experience in the stock market -- and enough assets that they can afford to lose all of their investment.
Most newer investors can’t afford to lose hundreds or thousands of dollars on a bad stock pick. Sticking with large, stable companies gives you the best odds for long-term growth. Investing in risky companies is more akin to going to Vegas and putting it all on black. You may double your money, but the odds are not in your favor.
Start by building a portfolio of strong, reliable companies and then add riskier stocks later on. Doing so will ensure you have a stable base and won’t lose it all due to one stock taking a big drop. I have a couple of high-risk stocks in my portfolio, but I didn’t buy them until I had a few years of experience, enough other stocks to steady my portfolio, and sufficient assets that I could afford to lose 100 percent of what I invested in the riskier companies.
If you meet the same criteria, riskier stocks may be a reasonable decision. But if you are just starting out, you’re better off avoiding these sorts of stocks and playing it safe.