The stock market is an excellent way to build wealth, but it's crucial to invest in the right places. It can be tricky to separate the smart choices from the dangerous ones, but doing so helps you avoid a financial disaster.
While all investments carry some degree of risk, some are far riskier than others. By avoiding the following three types of investments, you can protect your money to a great extent.
1. Penny stocks
Penny stocks trade for less than $5 per share, and many are priced at less than $1. The types of companies that issue penny stocks are generally small businesses, and they typically aren't listed on major stock exchanges.
Penny stocks are risky for a variety of reasons. First, their prices can fluctuate wildly. Smaller businesses tend to be more volatile than larger corporations, so it's common for penny stock prices to swing high and low.
In addition, it can be difficult to research penny stocks before investing in them. Smaller businesses often don't have lengthy histories, so it's challenging to predict whether a stock will perform well based on the information available. For these reasons, penny stocks are best suited for investors with a high tolerance for risk and uncertainty.
Where to invest instead: A smart alternative to penny stocks is buying fractional shares. Like the name implies, investing in fractional shares means you're buying only a small portion of a share of stock. This makes it much more affordable to invest in pricey stocks, and allows you to buy shares of big-name companies for just a few dollars. Because you're investing in large companies with strong track records, fractional shares are far safer than penny stocks.
2. Risky companies with high dividend yields
Dividend-paying stocks can be a smart investment, but it's important to make sure you're looking at the big picture and not just the dividend yield.
Just because a company pays a large dividend doesn't mean it's a smart investment. Some businesses may boast a high dividend yield, but the company itself isn't growing. Or maybe the dividend has been steadily decreasing year after year, which is a signal that the company is struggling financially.
If you find yourself chasing dividends, you may end up inadvertently investing in a risky company. And no matter how much you're receiving in dividends, it's not worth putting your savings in danger.
Where to invest instead: If you're looking to invest in healthy companies with strong dividend yields, your best bet is to focus on the Dividend Aristocrats. These are companies that have consistently increased their dividends for at least 25 consecutive years. Many of the organizations on this list are household names, such as Coca-Cola and Johnson & Johnson, and have proven track records of success.
Initial public offerings (IPOs) are when companies issue shares to the public for the first time. IPOs often create a lot of buzz, but they can be risky because there's so much uncertainty surrounding them.
It can be difficult to tell how a stock will perform when it's brand new to the market. Also, it's easy to let emotion get the best of you with an IPO. Some companies are overhyped leading up to their IPO, then they underperform. Case in point: When Lyft went public in early 2019, it gained a substantial amount of hype. Immediately after its IPO, however, its stock price began to plummet, and it ended up falling by about 43% by the end of the year.
Where to invest instead: Rather than jumping on new stocks as soon as they hit the market, aim for companies that have traded on the public markets for at least a year. While these companies can still be risky, you'll have a better idea of how the stock will perform. It will also give you more time to investigate a company's financials to decide whether it's a solid long-term investment.
Choosing the right investments can be challenging, so doing your due diligence is crucial. By avoiding some of the riskier types of investments and making more-stable choices, you can limit your risk while maximizing your gains.