Investing in the stock market is a smart move, and it's an effective way to generate long-term wealth. However, investing in the right places is critical.
Not all investments are created equal; some are riskier than others. While taking on more risk can sometimes result in greater earnings, there are some cases where the risk outweighs the potential rewards. These three investments can be incredibly risky. It's generally best to avoid them unless you're willing to lose a lot of money.
1. Penny stocks
Penny stocks are stocks that trade for less than $5 per share, and many of them trade for $1 or less per share. They can be attractive for investors on a tight budget, but they carry substantial risk.
The companies issuing penny stocks are usually smaller businesses with little to no history. That makes it hard to research the company to decide whether it's a solid investment, and sometimes a single piece of bad news can cause the stock price to plummet.
In addition, penny stocks generally trade infrequently. This means it may be harder to sell if you want to get out. If you get stuck with your shares and then their prices sink, you could lose a lot of money.
2. Leveraged ETFs
Exchange-traded funds (ETFs) are groups of securities that track a particular stock market index. A traditional ETF tries to mirror the returns of an index; a leveraged ETF attempts to amplify them.
With a traditional ETF, if the securities in the underlying index move by 1%, the ETF will move by 1% as well. With a leveraged ETF, if the securities in the index increase by 1%, the ETF will aim to increase by 2% or 3%.
Leveraged ETFs use complex and risky strategies to try to increase earnings. While you could potentially see extraordinary gains, you could also experience extraordinary losses. These investments are also designed for daily trading, not for long-term investing. For that reason, they're best left for day traders who can stomach the extreme risk.
Short-selling is not so much an investment as it is an investing strategy. When you short a stock, you're betting that its price will go down. You borrow a share of stock from a brokerage, sell it for its current share price, and then wait. If the price drops like you expected, you buy back the share at the lower price, return it to the brokerage, and make a profit.
The problem with short-selling is that there are limited potential earnings but unlimited potential risk.
Say, for example, you buy a share of stock the traditional way for $100. The most you can lose is $100, but you could earn an unlimited amount depending on how much the stock price increases.
Short-selling is the opposite. If you sell a share of stock for $100, the best-case scenario is that the price drops to $0, and you make a $100 profit. But if the stock price jumps to, say, $300 per share, you still have to buy back that share eventually to return it to the brokerage. If you sell it for $100 and buy it back for $300, you've just lost $200.
Short-selling isn't always a bad strategy, but if it doesn't go according to plan, it can be incredibly expensive. For that reason, it's best left to experienced investors with deep pockets.
Where to invest instead
One of the best ways to succeed in the stock market is to take a slow, steady approach. Invest in solid companies that have strong fundamentals and are likely to perform well over the long term. You won't get rich overnight with this strategy, but you're also far less likely to lose large sums of money.
There's no good way to get rich quick in the stock market. Using risky investing strategies to try to earn significant gains in a short period of time could backfire and cost you a fortune. By taking a long-term approach instead, you can generate wealth while limiting your risk as much as possible.