It is common advice in the financial sector to diversify your portfolio and buying stocks is one way to do that. Sites like reviewsbird.co.uk provide information on stock investment and reading reviews before investing your money is always a good idea.
Depending on your financial status, the type of stock you buy varies and you might be tempted to go for the cheap stocks. Before you add them to your portfolio, do you wonder if this is a good investment?
It’s actually a poor strategy that can deprive you of gains and break essential rules for diversification. It can also expose you to failing businesses and low-growth industries.
There are a few things you should take into consideration if you wish to invest in cheap stocks.
The nominal share price is usually unimportant
Early investors can look at a $20 stock and conclude that it is lower in price than a $50 stock because they believe they can buy more shares for the same purchase price. This is valid in a simplistic context, but it is a flawed approach to the development of portfolios. The amount you pay does not accurately represent the capacity of the company to generate such profits in the long run.
Investors should calculate the total amount of savings that should be installed in the stock market and then expand that amount, into fractions across various assets.
In actual fact, a $20 stock for a company with a $0.20 earnings per share (EPS) and no economic activity is more costly than a $50 stock that generates steady $1 dividends annually consistently.
Some value traps come as cheap stocks
Value traps are stocks that seem inexpensive but are unnecessarily risky deals in the end. A value trap may also be a previously profitable business that is failing, beginning a significant drop from which it can never recover.
Diversification may become a serious challenge
Concentrating largely on cheap stocks poses significant barriers to diversification. It will also deprive investors of adequate exposure to high possibilities for growth. Cheap stocks have the benefit of costing well below high price stocks, but they also happen to be more volatile. Per best practice, investors should equalize the distribution between highly risky and less risky stocks, as each category has phases of higher returns over a complete economic cycle.
There could be institutional oversight
Although the Securities and Exchange Commission carry out strict monitoring of high price stocks, firms with cheap stocks often do not operate on international stock markets and are not obligated to disclose reports with the Securities and Exchange Commission. Almost all of the data that investors will use to pass judgement on the worthiness of a cheap price stock will not come from reputable sources.
You may want to avoid purchasing single stocks entirely, given the risks of buying stocks based exclusively on their costs. You can choose to invest in a broad market index mutual fund that imitates the wider market. This is a suitable alternative if you are an investor seeking a minimalist approach.
Instead of purchasing cheap stocks as a lay investor, it is certainly a good idea to consider diversified index funds.