If you’ve ever been tempted to buy a stock because its price is soaring and it’s popping up on social media and in headlines, you’re not alone.
But while some of these stocks that attract tons of attention may be positive additions to your portfolio, others don’t have the fundamentals to perform well over the long term, and can lead to significant losses for investors who buy at the top.
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You don’t have to search for the next big thing. Diversifying into high-quality, dividend-paying companies and investing in broad market funds instead helps lower your risk. Here are five red flags that can help you determine whether you’re buying an overhyped stock.
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1. Poor fundamentals
No matter how popular a stock is, if the company doesn’t have strong fundamentals, there’s a good chance its price won’t continue to rise over the long term. Some common metrics used to assess a stock’s fundamentals are cash flow, earnings per share (EPS), price-to-earnings ratio and dividend yield.
Keep in mind that it’s possible for a company to be unprofitable for several years after going public, eventually report its first profit and generate tremendous long-term returns. And remember that picking the stocks that will soar based on these types of metrics is challenging even for the pros on Wall Street.
2. Social media-driven buzz
There has to be more to a stock’s long-term performance than what the CEO posts on social media. While executives posting about their companies can generate more attention to businesses that are delivering high revenue and net income growth, those same companies can become overvalued.
Many people post about their favorite stock picks on social media, too. But be careful of investing in a company just because you see it mentioned over and over again online.
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3. Excessive debt load
Compounding is a powerful financial force that helps many people retire early, but this same force can hurt companies that are deep in debt. It’s challenging to turn the ship around when interest expenses make up a large portion of a company’s total expenses. These corporations may end up paying a lot of interest, limiting their ability to invest in employees and research and development.
4. Sector concentration
Another big warning sign may be prioritizing a single sector that is hot right now instead of diversifying your portfolio. While some investors make tremendous returns with this strategy, it’s possible to lose a lot of money in flashy sectors if aren't careful with your asset allocation.
Diversifying into broad market index funds in addition to holding sector-specific funds can help reduce your potential downside risk.
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5. The no-moat company
Wall Street experts often look for companies with distinct advantages over competitors. Walmart, for instance, has more than 10,000 locations and offers low prices on various products, while Nvidia developed the chips that help power many of the artificial intelligence innovations we see today. Those are vast competitive moats. If a company is getting a lot of attention but doesn't have a competitive moat, it could mean it's not up for generating strong returns over the long term.
