With great power may come great responsibility, but great risk does not mean great potential returns. Don't fall for this trap! Instead of assuming all risky investments are growth investments, remind yourself of two key principles.
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High risk does not mean high reward
Risky companies, particularly penny stocks, receive a level of undeserved attention from investment blogs and the dark corners of investing Twitter. A penny stock is a company that has a share price under five dollars, and countless self-proclaimed "successful investors" swear they've made fortunes overnight by trading these dirt cheap shares. However, you should take these gurus' claims with a grain of salt. Penny stocks may simply represent businesses that have yet to establish their reputations -- or they may be outright frauds.
These thinly traded companies dwell in the OTC market, where they are not held to the stringent reporting standards of a major exchange like the NYSE. Such companies often draw in investors with a low share price, only to leave them holding the bag when larger investors sell for a quick profit -- and send the original price plummeting even further.
If a company seems incredibly risky, it may simply not be worth your time. But there are early stage companies out there that make great speculative investments. For example, Virgin Galactic (NYSE: SPCE) is a company that faces two very binary outcomes; either it will succeed with its mission of space travel, or it will not. But unlike penny stocks, it has a visionary founder, Richard Branson, with a past track record of success; it's traded on the New York Stock Exchange, which means it has to meet stricter listing requirements; and it has a comfortably large market capitalization of around $5 billion. These factors make Virgin Galactic's risk a lot more tolerable than investing in a shady penny stock.
High reward doesn't mean high risk
A well-run business that is vital to its clientele ultimately poses very little downside for its investors. These companies are able to consistently grow even as they produce abundant cash flow.
Trash collector Waste Management (NYSE: WM), water utility holding company American Water Works (NYSE: AWK), along with electric utility holding company NextEra Energy (NYSE: NEE) have demolished the market over the past decade. These companies expose their investors to relatively little risk, because they provide services essential to the day-to-day lives of millions of people. While that must-have status makes them safer investments, each of these also has a long runway for growth ahead -- after all, we're going to need water, waste removal, and electricity for a very long time.
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Minimize your risk by buying great companies
Investing comes with a certain degree of risk, but not all risk is equal. Reduce your risk by buying a diverse array of well-run companies with the goal of holding them for a very long time. Despite how tempting penny stocks may seem, plan to avoid them altogether. If you decide that you want to invest in a more speculative company, make sure that you aren't giving it too much of your portfolio. If a speculative investment works out, owning a small amount goes a long way, but if it doesn't, you don't want to own a lot. Finally, don't make the mistake of overlooking a boring business because it isn't as flashy. Invest in the companies you believe in, and plan to hold them for the long run.
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Edward Ruger owns shares of American Water Works, NextEra Energy, Virgin Galactic Holdings Inc, and Waste Management. The Motley Fool owns shares of and recommends Virgin Galactic Holdings Inc. The Motley Fool recommends NextEra Energy and Waste Management. The Motley Fool has a disclosure policy.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.