What Types of Stocks Do You Avoid?

When you buy a stock through one of the major exchanges, such as the NASDAQ and the NYSE, you enjoy the protection of a highly regulated market under the jurisdiction of the U.S. Securities and Exchange Commission (SEC). Stocks sold outside these major exchanges, often called penny stocks, are largely unregulated. Their earning reports may be accurate or they may be fraudulent. A retail investor who buys them will have no easy way of telling the difference. The sellers of these stocks sometimes engage in conspiracies to defraud investors, such as the "pump and dump" scheme, where a small group of insiders artificially inflates the value of a given stock and then rapidly sells out, causing the stock price to plummet and leaving the remaining investors with large losses.

Stocks with very low average daily trading volumes are inherently volatile -- just a few thousand dollars worth of trades in a given day can make the price of a low volume stock jump or go down significantly, which also means that the price can be manipulated without a major investment. They can also be hard to buy and sell.

The unprecedented rise in U.S. residential real estate prices from 1998 to 2006 is one instance of a bubble. Bubbles are often ignored, and investors keep buying into them -- one of the main reasons for the bubble in the first place, a phenomenon Yale Economist Robert Shiller has termed "Irrational Exuberance." When the value of an asset rises significantly above its historical growth rate over a short period of time, that's one indication of a bubble. When the ratio of price to earnings [P/E] in a particular sector soars far above historical P/Es in that sector, that's another. When televised financial gurus explain why a particular stock group, such as tech stocks in the early 2000s, are no longer bound by basic economic concepts like regression to the mean, keep them out of your portfolio until the price has significantly dropped.

When stocks in a particular sector do unusually well, you may be tempted to buy more of the same stocks or similar stocks in the same sector. Usually that's a bad idea. The very fact that a particular stock group does unusually well means that your assets are beginning to concentrate too much in a single sector, exposing you to unnecessary risk. Instead of buying more of your best performers, begin selling them when they exceed 5 to 15 percent of your portfolio. Diversification is the single most important requirement for financial survival in the market.