I’m a Financial Advisor: Don’t Invest Your First $5,000 in These 5 Kinds of Stocks

25/06/2024

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Investing in the stock market is one of the best ways to build wealth. But figuring out what to invest in when you’re first getting started can be overwhelming.

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There are plenty of places that tout “best stocks to invest in right now,” but many are poor investments or simply too high risk for beginners.

We asked a financial advisor about what to avoid when you’re investing your first $5,000. He gave us five types of stocks to avoid when you first start investing.

Types of Stocks To Avoid With Your First $5,000

Here’s a closer look at what to stay away from.

1. Stocks With a Price-to-Sales Ratio Above 10 Times

When evaluating an investment, it’s a good idea to research whether the company is overvalued or not. One smart way to do this is by checking the price-to-sales ratio.

“The price-to-sales (P/S) ratio is a valuation metric that compares a company’s market capitalization to its revenue,” said Ryan Jacobs, financial advisor and founder of Jacobs Investment Management. “A P/S ratio above 10 indicates that investors are paying a premium for the company’s sales, which might not be justified by its earnings potential. High P/S ratios often reflect overvaluation, making these stocks riskier. For beginners, it’s better to avoid these stocks and focus on companies with more reasonable valuations.”

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2. Stocks Suspected of Fraud

While stocks that are publicly traded are usually on the up-and-up, some companies get caught in criminal activities and the stocks plummet quickly. That is why investing in a stock is much more than just numbers, but investing in a company with transparent financials and trustworthy management.

“Fraudulent companies manipulate financial statements to mislead investors,” Jacobs said. “Such stocks might show promising figures, but the underlying business could be weak or non-existent. Investing in these companies can lead to significant losses once the fraud is exposed. Beginners should focus on companies with transparent and trustworthy management to avoid the pitfalls of fraud.”

3. Speculative Stocks Based on Future Growth

In a world of meme stocks (looking at you, Gamestop) and day trading, you probably shouldn’t bet your first few thousand dollars on speculative investments that pose a high risk. As quickly as some of these stocks jump in price, they can plummet just as quickly — or more — and take your money with them.

“Speculative stocks promise high returns based on potential future growth rather than current performance,” Jacobs said. “These stocks are often hyped up and come with substantial risk, as their success depends on uncertain future events. For new investors, it’s wiser to invest in companies with established track records and stable earnings, reducing the likelihood of significant losses.”

4. The Most Popular Stocks

When stocks start hitting the financial news, they may already be a bit overvalued. When your Uber driver starts giving you hot stock tips, it’s probably not a good idea to go “all in” on a recently popular stock.

“While popular stocks like those of major tech companies might seem like safe bets, they often come with inflated prices due to high demand,” Jacobs said. “These stocks can be volatile and may not provide the steady growth a beginner investor needs. Instead of chasing the trend, beginners should look for undervalued stocks or those with consistent performance over time.”

5. Value Traps

Value investing is the practice of reviewing company financial statements to find stocks that are undervalued on paper, which can lead to outsized growth in the future. But not all value stocks are actually all that valuable — they might be a trap.

“Value traps are stocks that appear undervalued based on fundamental analysis but are cheap for a reason,” Jacobs said. “These companies often have underlying issues, such as declining revenue or poor management, that hinder their ability to grow. Investing in value traps can tie up your capital with little to no returns. It’s crucial to research thoroughly and avoid companies with unresolved fundamental problems.”

How To Invest Your First $5,000 Instead

Now that you know what types of stocks to avoid, here are a few good ideas on how to invest your first $5,000 instead:

1. Index Funds

Instead of focusing on individual stocks and trying to pick a winner, why not buy hundreds of stocks within a single investment? That’s where index funds come in.

“Index funds are a perfect starting point for beginner investors,” Jacobs said. “These funds replicate the performance of a specific market index, like the S&P 500, providing broad market exposure and diversification. Index funds typically have low fees and offer steady growth over time, making them a reliable option for those new to investing. They reduce the risk of picking individual stocks and help build a solid foundation for your investment portfolio.”

2. Berkshire Hathaway

Did you know that you can invest like Warren Buffett? Buffett’s holding company, Berkshire Hathaway, is a publicly traded company that allows investors to buy shares and reap the rewards of one of the greatest investors of the century.

“Investing in Berkshire Hathaway, Warren Buffett’s conglomerate, is an excellent way to learn from one of the best investors in history,” Jacobs said. “Berkshire Hathaway holds a diversified portfolio of high-quality businesses, managed by experienced allocators. For beginners, this stock offers exposure to a range of industries and the chance to understand sound investment principles. It’s a practical way to benefit from professional management while minimizing risk.”

3. High-Yield Savings Account

While investing your first $5,000 can be exciting, it’s important to have a cash foundation in place first. If you don’t already have an emergency fund, you might want to avoid the stock market altogether and simply park your first $5,000 in a high-yield savings account.

High-yield savings accounts offer much higher interest rates than your typical savings account, but still come with the same protections and access that a regular bank account does. High-yield accounts are paying over 4.00% currently, which is a great guaranteed rate of return. Plus funds are FDIC-insured up to $250,000, so you don’t have to worry about your money. Overall, parking some cash in a high-yield savings account is a great starting point for many investors.