These worst stocks and investments may seem like a good idea but will lose your money fast
Individual investors are notoriously bad at…investing. Between buying at the market’s peak and panic-selling, the average investor earned just 2.6% annually over the decade to 2013.
What causes investors to lose so much money in stocks?
Among the bad investing behaviors are three of the worst stocks and investment ideas you absolutely must avoid. These aren’t individual stocks or companies, that’s not what My Stock Market Basics is all about. Instead these are three bad investment strategies that investors get sucked into and end up missing their investing goals by a wide margin.
Investing along the stock market basics will help you avoid making most investment mistakes but avoiding these bad stock ideas is also critical to meeting your financial goals.
The Worst Stocks and Investments to Avoid
Like most bad investing decisions, these worst stock ideas start with a kernel of truth. Each is backed by seemingly solid reasoning that traps investors into pouring their money into the investment.
1) Possibly most dangerous of the worst stocks is what’s called the ‘falling knife’. This happens when the price of a stock tumbles on headlines or some other factor. Investors keep using the same profit estimates and outlook for the company even as new information implies otherwise.
Part of the reasoning is based on the idea that the market always prices stocks at fair value, a theory called Efficient Market Hypothesis. Despite the new information and uncertainty around the company, investors reason that the stock must still be worth something close to its prior value. What looked good at $100 per share looks even better at $80 and then $50 per share.
There are two problems with the falling knife that makes it one of the worst stocks in which to invest. First is where the nickname falling knife comes from…as in, have you ever tried to catch a falling knife? It’s tough to do it without getting cut.
Unless you’re a master at calling the bottom in a falling stock price, and I don’t know anyone that is, you are likely going to lose money as the stock keeps dropping over the short-term. Unless you’re ready to take big losses and hold on for the long-term rebound, just avoid this type of investment.
The other problem with the falling knife is that investors tend to ignore new information. They see the old stock price as a target and that any price under that is a great deal. To make up for losses as the shares continue to fall, they keep buying more shares and amassing a huge position in the company.
Pretty soon, the stock is a huge part of their portfolio and they’ve lost more money than they can afford.
This is exactly what happened to one reader, contributing to a stock market loss of $30,000 in less than a year.
Going after cheap stocks is ok, even after losing some of their value, but you have to be in it for the long-term and you need a good reason to believe that the outlook will improve eventually.
The best way to avoid being cut by the falling knife is by diversifying your value investments in a fund on Motif Investing. Motif allows you to group up to 30 stocks in one fund and buy the group with one commission. Creating a fund of your value stocks means you won’t be overly focused on any individual and the diversification will help smooth returns.
Some stocks may keep falling but those rebounding will help to calm your nerves and keep a long-term focus.
2) The second of these worst stock ideas is paying for future growth. Stocks are an ownership of future earnings so it makes sense that analysts try to predict future growth to come to a fair value for companies. As I write this, investors are paying a price of 17.9 times next year’s expected earnings of companies in the S&P 500.
That’s fairly expensive but nothing compared to some individual stocks.
The problem is when a company starts recording meteoric growth as a startup or on new technology. Wall Street gets euphoric about the company and bids the price of the stock up to ridiculous levels. Investors rationalize the higher prices by assuming that double- and triple-digit growth will continue into the future and earnings will eventually catch up.
Dare I say something bad about Tesla (TSLA)? Investors in the electric car maker are zealous about the company and its potential for social change…and they’re willing to pay dearly for the shares.
Even after falling 18% from this year’s high, the stock still costs 280-times the profits Wall Street expects for this year. Investors are basically assuming that earnings will continue to grow exponentially for many years even though sales are expected to slow over the next few years.
You see the same story in many other stocks and everyday a headline comes out to question growth at one of them. When that huge outlook for growth looks more uncertain, the stock price tumbles as investors head for the exit.
There are some investors that do well with what’s called ‘growth investing’ paying a premium for fast-growth companies but you have to have a limit to what you are willing to pay.
I make it a point to pay no more than 50-times earnings, no matter how high profits are expected to grow. I miss out on some high-flyers but I also avoid the inevitable crash in most of these bad investments.
Instead of paying for future growth in a single company, try investing in future themes. One of my favorite investments is my American Future Fund, an investment in the three sectors with huge demographic forces in their favor. Investing across a wider theme means you benefit from these overwhelming trends but are not exposed to any one particular company.
3) Last of our worst stock investments is betting with the short-seller. Selling a stock short means you borrow the shares from your broker to sell with the idea that you will buy them back later. Selling the shares now nets you the price of the shares. If you believe the stock is over-valued then you can buy them in the future for a lower price to satisfy the borrowed number of shares to your broker.
Despite what some investors believe, there’s nothing wrong with short selling. If the market has bid up the price of a stock to insane heights or if you find that the company has lied on financial documents, you have the right to profit from your opinion.
What makes this one of the worst stocks to get into is following short-sellers into the idea. This happens when some famous investor goes online or makes a TV appearance to denounce a company. If the argument has any merit or sometimes simply if the investor is famous enough, the shares plunge as investors sell their shares or others sell the stock short.
What happens more often than not is that the stock falls immediately to about as low as it is going to drop, especially as more investors rush in to short it. I’ve worked with short sellers and hedge fund managers.
Anyone appearing on TV to give you the ‘scoop’ already has shorted the stock and has their own agenda. Often, the stock has already fallen about as far as it is going and the investor wants to go public to get a little bigger drop. When the shares drop on their ‘advice’ they buy back at the lower price to cover their position.
Short-selling is OK but be skeptical of the trades you hear on TV and only invest if you think the stock price still has a reason to go lower.
These aren’t the only three bad investments than can lose your money but are three of the worst stock ideas that trap investors. As is always the case, meeting your investing goals should depend on your own personal goals and not the potential in a stock pick. Make sure an investment meets your long-term needs before getting sucked into a bad stock.