What kind of stocks should I avoid?
Investing in the stock market is a great way to make some money in the long-term. People have been investing in stocks with the plan of simply letting their investment sit there and grow as the price of the firms' stocks grows.
In the meantime, investors can sometimes receive dividends, which basically provide them with passive income. This money can then be used in everyday life, or for further investments.
The bottom line is if you diversify your portfolio adequately, and if you make good investment decisions when choosing the stock to invest in, you can make quite a bit of money over the years.
Of course, there is more to it than that. You must also possess strong discipline, and proper knowledge of the stock market, the companies you can invest in, the understanding of price movement, and more. But, provided that you do your homework, stock investments can be a great way to ensure a fair amount of money for your retirement days, and alike.
With all that said, an important thing to know is what kind of stocks you must absolutely avoid at all costs unless you are a risk-taker. There are some types of companies that should be avoided by anyone, and especially by inexperienced and new traders and investors.
Today, we are going to talk about these stocks, and see what types of firms you should avoid in order to secure your money and avoid unnecessary losses.
The most important rule of stock investing
Stock investing is filled with all kinds of rules, meant to help the investors protect their investments and minimize losses. However, the rule that tops all of them is really just an extension of good, old common sense, and that is to avoid things that you don't understand.
If you don't understand something well enough, you cannot make an accurate assessment of its price. That means that you cannot create a proper investment strategy and that you are likely to see losses. That is unless you end up being lucky enough to make the right call without knowing what you are doing — which is not something that tends to happen often.
What does it mean to not understand the company?
It is rather simple, really. If you don't or can't understand how the firm in question is generating revenue, or what its business model is, or even what services or products it offers, it is best that you avoid it.
This does not only include companies that are purposefully vague about their products and/or services. It can also include completely transparent firms that simply deal with things that fall out of your area of expertise, education, or ability to understand.
For example, not a lot of people has a proper understanding of microelectronics, semiconductors, and alike. Most of us don't know what those even are, let alone how they work, or how they are made, and whether they are any advancements in this industry, what to expect, and alike.
Without knowing those things, you can't understand the market demand, future prospects, or even what competitors to keep an eye on.
Of course, you can learn those things. However, that would likely require too much time and effort, and in the end, you might even decide that it is not the right thing for you to invest in, at all.
So, skip all of that, and simply go for companies that deal with something that you don't have to start learning from scratch in order to even understand what it is they do. Instead, go for firms that you can understand — those that offer consumer goods, cars, utility, and similar goods and services.
Which types of companies to avoid
With that out of the way, let us discuss the kinds of firms that you can avoid, whether you can understand what it is they do or not.
1. Low-liquid firms
One thing that you should always keep in mind when choosing a firm whose stocks you wish to invest in is whether or not it has liquidity. Basically, it needs to have activity when it comes to purchases and sales of its stock. You need buyers and sellers so that you have someone who would buy the stock if you ever decide to sell it.
Low-liquidity firms cannot offer that. Such companies simply do not attract interest, most likely because of the fact that they are failing, and they have no plan of getting back into the saddle. Investors tend to learn about those things, and they do not want to buy the firms' stocks.
Meanwhile, the price continues to drop, with you and other unfortunate investors owning its stock, and not having anyone to sell them to.
Exiting low-liquid firms is difficult and always very stressful. Due to all of these negatives, it would be best to simply avoid having to deal with such companies, in general.
In fact, it is best to try and avoid firms that have a daily average trading volume of fewer than ten thousand shares.
The simplest way to avoid such firms is to simply target those with high daily trading volume. Alternatively, you can also try studying the difference between the firm's Ask/Bid price. If the difference is small, that means that liquidity is high, and the firm is among the better options for investment — at least as far as this aspect is concerned.
2. Falling knife firms
There is a term for companies that are a very risky investment, and that term is 'falling knife.' Basically, just like the knife spinning in the air and heading for the ground, the companies that fall under this category are unreliable investments that are more likely to severely damage you than be a profitable option.
After all, you should never try to catch a falling knife, and for most people, that is a well-known instinct.
However, this is also a common mistake made by new investors, who think that they see potential in these firms, and are investing large amounts in companies that continue to see drops in their prices.
These investors are typically convinced that the firm is just seeing a rough patch and that this is the right time to invest.
Unfortunately, this is usually not the case. If the firm's stocks are continuously losing value, and especially if it keeps seeing significant drops, there is always a reason for that. The market knows it, even though you may not be aware of it. And, the market decided to punish the firm for it.
The reason for such negative price performance can be anything, and that is not the point. The point is that the firm is unreliable and that you should not invest in it. Especially not when there are thousands of other firms that you can explore and invest in, many of which are much better and capable of bringing a decent profit.
So, just like with falling knives, it is much better to avoid trying to catch the opportunity and risk hurting yourself. There are experts out there who might be trained in doing that kind of thing. However, if you are not among them, it is best to play it safe, and not waste your money.
3. High-debt firms
Having debt is not a great thing for anyone. Individuals suffer from debt everywhere and all the time, and that is a big problem for them. However, when companies suffer from debt, that is a major problem for everyone involved, including someone who may have simply invested in the firm's stocks.
Think of debts as in holes in a ship. If the ship has a leaky bottom, the water will keep entering, slowing the ship down, and eventually threatening to drown all on board.
The situation is the same with firms; If the company has a lot of debt, it means that it is not making money — it is borrowing it. This alone would be reason enough to avoid it. Of course, there are firms that borrow money, but that is often for a major project, and they end up being extremely successful in developing it.
This success allows them to return the borrowed funds, and have enough left to make the borrowing worthwhile in the first place.
But, if the firm's debt continues to increase or remain the same instead of going down, there is something very wrong with the company, and it is likely to drag you down with it if you opt to invest in it.
You can find out whether the company has a lot of debt by studying its balance sheet. Also, you should check its debt/equity ratio, and avoid every firm that has a ratio above 1.
With all that said, don't be afraid of investment firms that have debt. Just don't invest in those that have high debt, and whose debt seems to be increasing over time. Debt CAN be good for business in some situations.
For example, if a firm has a very low debt level, and it decides to add a new one in order to start a project that might bring massive revenue, that is a good thing, as mentioned before. So, debt is not always bad. If it goes up and down, it shows that the firm is active and that it is doing something with the money. If it only grows, however, it is time for you to move on.
4. Low-visibility firms
Lastly, you should also try to avoid investing in the stocks of the so-called low-visibility firms. These are the companies that are extremely vague about their information, or if they don't even offer any data.
This is often seen among micro-cap and small firms. It is not common, as such companies do not tend to last for very long. But, there always seems to be a few of them that make their information very difficult to find.
They tend to lack transparency, and you cannot find the necessary data anywhere on the web. Their sites are very vague, financial websites don't know what to make of them, and your top efforts at doing research return next to nothing.
You can easily recognize these firms after only a few minutes of searching by the fact that you still know next to nothing about them. Investigating such companies can be rather tedious, not to mention the fact that there is always the chance that the information you did manage to find is incorrect.
Data manipulation is not uncommon in such scenarios, so it is best to try to avoid any such firm, whose data is purposefully being undisclosed, vague, or simply fake.
Investing in various firms and diversifying your investment portfolio is one of the best ways to ensure that you won't see major losses. Instead, diversification is a basic strategy for every successful investor.
With that said, it is not only important to invest in many different firms — it also matters which companies you are investing in. There is an entire list of categories that some companies that are considered bad investments can fall into. We have mentioned some of the biggest categories of this kind above, so keep an eye out for that when you are searching for the next firm whose stocks you plan on buying.
In the meantime, if you are new, don't be ashamed of investing only in the safest options out there. You will need time to develop your sense of the market, the necessary skills, and to learn how to read the market, where to get fresh information from, and how to use it to your advantage. Play it safe, and you are far more likely to earn money than to lose it.
Author: Ali Raza - A journalist, with experience in web journalism and marketing. Ali holds a master's degree in finance and writes extensively about the financial markets and fin-tech industries.