Stocks to Avoid: Why You Want to Avoid Risky Stocks
Warren Buffett once said, “The first rule of an investment is don’t lose money. And the second rule of an investment is don’t forget the first rule.” The quote may seem like it would suggest avoiding stocks now that the stock market is tanking, but the Buffett quote refers to a permanent loss of money. Not necessarily stock prices going down in the short-term. This article will examine stocks to avoid during certain circumstances.
Investors timid about buying a stock because of persistent inflation, rising interest rates, or any other outside factor may feel relief by reflecting on Buffett’s words. For instance, though these factors may cause stocks to fall for the rest of the year, they may also be opportunities to buy your favorite company’s stock at a lower price than ever before.
On the other hand, inflation or rising interest rates may affect a company more than others. If inflation or interest rate continue to hamper those companies, their stocks will likely tumble further. The thing to remember is that inflation or rising interest rates are risks to these companies. Those risks are always present, not just today. In other words, avoid risky stocks, always.
Stock to Avoid During Inflation
Persistent inflation can be devastating to people and businesses alike. Especially the people and companies that cannot increase their income when inflation increases their everyday costs. For instance, when inflation causes expenses to go up, retired folks on fixed incomes or lower-income folks may have a hard time paying for the bare necessities.
Same with businesses. If expenses go up, but the company makes the same about of revenue on every product or service, their profits fall or go into negative territory. This is not a good scenario for shareholders.
Companies that can increase their sales when costs rise have pricing power. For instance, if the company sells a product that is so popular that customers are willing to pay a higher price than go without it, then the company has pricing power. Pricing power comes from a few different sources.
If a company is the only place to get a certain product or service, it probably has pricing power. In other words, if a customer has to jump through hoops or go to great lengths to get a competing product, the company can likely charge a higher price if it needs to.
Stocks to avoid during inflation are the stocks of companies that do not have pricing power. Most commodities do not have pricing power because all the products are the same. Other highly competitive industries also lack pricing power.
Stocks to avoid during inflation are ones without pricing power. Of course, investors should use a long-term time horizon and know they might want to avoid these stocks all the time.
Stocks to Avoid During a Market Crash
Investors looking for stocks to avoid during a market crash must first identify a market crash. If we knew when a market crash would start and end, we could do really well for ourselves. Unfortunately, we don’t know when those things will happen. No one does.
The stock market has a mind of its own, and it is very temperamental. The stock market can go up or down for any number of reasons. So, predicting its movements, big or small, is impossible. But many investors try to time the market and jump in and out accordingly. This is a mistake, it’s important to know when to avoid stocks.
For instance, because we cannot predict stock market movements, most investors did not see the stock market downfall this year. Now it may feel like stocks will continue to fall indefinitely, they won’t.
If you’ve watched your investment account fall this year and jumped out of stocks, you’ve taken a permanent loss that Buffett advised us not to do. The next step is to predict when the market will reverse and go back up. Again, we won’t know that until after it happens. At that point, we may be watching the stock market recover, but not our account.
Market timing can lead to disastrous returns. For instance, for the 20 years ending in 2019, the average equity fund investor earned 4.25%, while the S&P 500 index earned 6.06% over the same period. Why? Investors tend to buy high when it feels good and sell low when the market crashes.
Maybe avoiding stocks during a market crash is not the best solution. Here are a few alternatives when considering stocks to avoid.
Alternatives During a Market Crash
The emotion of a crash and euphoria of a bull market compels us to buy high and sell low. Rather than avoiding stocks during a market crash, consider avoiding emotional decision-making.
Averaging Down: When a stock goes down, buy more. It may seem like a tough pill to swallow, and it may not immediately work, but it can be a great way to increase your long-term returns.
Dollar-Cost Averaging: Like averaging down, dollar cost averaging is a mechanical way to take the emotion out of investing. Put money into your investment accounts regularly and ignore the ups and downs of the stock market.
About BJ Cook
BJ Cook is a long-time stock nerd. He has held several roles in the equity research world and earned the right to use the CFA designation in 2014. When he’s not writing for Investment U, you can find him searching for new investment ideas. Outside the investment community, BJ is a die-hard Cubs fan.