One of the surest ways to get turned off from investing is to bet on a loser. Unfortunately, the culprit for a lousy pick can often be found by looking in the mirror.
Buying stock in a company involves inherent risks often beyond your control: The company could file for bankruptcy, endure a prolonged PR nightmare or flounder as its revenue dries up. But investors also find ways to justify terrible investments.
If you’ve described your logic for investing in a particular company using one of the following phrases, back away from the “buy” button.
1. ‘It’s cheap.’
“Cheap” stocks have an understandable appeal — you can buy more shares. But basing investment decisions on price alone is problematic. There might be a reason the stock price has plummeted or was low to begin with, including company- or industry-related dynamics, broad economic factors or dwindling support from big investors.
Considering a stock with a price that slumped recently? Review its price chart from the past year or longer. If the line has gone down for several months, you’re betting against the masses. Such investments can turn profitable — just look to the financial crisis for hundreds of examples — but you should understand why the price has fallen, because it could easily go even lower.
And there are special dynamics involved with low-priced stocks — those that cost less than, say, $10. They can be more difficult to buy or sell (what’s known as illiquid), experience higher volatility (meaning prices swing wildly) or languish in a narrow price range, limiting potential returns.
Finally, if you’re eyeing “ultra-cheap” microcap or penny stocks, tread carefully. These stocks are so prone to fraudulent activity that the Securities and Exchange Commission recently issued an alert about their risks.
2. ‘I got a hot tip.’
Skepticism is useful when receiving market advice. This is true even when your stock tips come from a trusted financial advisor. When a friend, family member or stranger — on TV, online or on the street — is touting a particular stock, you should be even more wary.
Consider whether the person has something to gain from you buying or whether he or she has the expertise to offer the advice at all. And remember that tips can be criminal if they’re based on information that’s not public.
Worst case scenario you face from doing research: You buy later and at a slightly higher price. Best case scenario: You steer clear of a dud.
» MORE: How to dodge stock market scams
3. ‘I love the company’s product.’
You’re so brand-loyal that your closet, garage or electronics collection is an ode to a particular company. It makes sense to become a shareholder, right? Not necessarily.
You might know a company well from a consumer’s perspective, but other factors affect its stock price — such as analyst recommendations, investors’ perceptions of its value and its popularity among exchange-traded funds.
Meanwhile, shares of many companies that produce popular products trade at higher prices, limiting the number you’ll be able to afford. It can be exciting to own even one share of a great company, but many online brokers have flat commission fee structures, which means you’ll face higher per-share expenses and tie up money that could be invested elsewhere.
Don’t let brand loyalties overpower your long-term investment goals. Investing in companies you know can make you more engaged, but a well-diversified portfolio should be your overarching goal.
4. ‘I’ll at least make a quick buck.’
The long-term returns associated with broad market investing are well-documented, but you can’t — and shouldn’t — extrapolate that to individual stocks, especially if you don’t intend to be invested for long. Initial public offerings are especially prone to get-rich-quick lore, but there are plenty of examples to the contrary. As of this writing, the Snapchat IPO from earlier this year stands as a good cautionary tale: The stock is currently trading well below its highs, which came shortly after the company went public.
Many people set out with shorter investing horizons in mind, intending to actively trade stocks. If that’s you, make sure you’re fully aware of the inherent risks, and be prepared to pay higher capital-gains taxes and trading costs.
If not, leave the stresses of short-term market swings to the professionals, and don’t let the market’s recent surges convince you that the good times will never end. Over the course of your investing career, you’ll undoubtedly experience periods of turbulence.
5. ‘I want to invest in something.’
With so many great reasons to invest in the stock market — including the proven long-term returns and proverbial seat at the table you gain as a company shareholder — don’t let a bad reason compel you to join the action.
Piling money into a single stock because you’re eager to play the game could be disastrous. There’s a reason so many investors stick with broad index funds: It helps reduce risk. If you’re sitting on a pile of cash — from $500 to $100,000 or anything in between — you have a variety of investment options.
Building a well-diversified portfolio takes time and planning. But you’ll be thankful for exposure to other assets, such as bonds, when the stock market takes a hit.