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Five Red Flags to Watch Out for When Investing in Stocks

David Capablanca  |  June 21, 2023

A look at some of the most common pitfalls of investing in stocks, and how you can successfully navigate these red flags for investors.

Stock market participation has become an integral part of America’s financial infrastructure, with 61% of Americans now owning stocks — the highest level since 2008. We know that the best way to grow your money for the long haul is to invest, and historically, the stock market has consistently offered higher returns than most other investments. (Over the last decade, the market has gained an average of 12%… compare that to bonds, which earned about 1% — not even close to keeping up with inflation.) But just as it can be thrilling for an investor to see solid returns, it can also be disheartening when investors encounter red flags that mean you should put your money elsewhere.  

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Whenever you invest in the market, there’s the thrill of owning a stake in a (hopefully thriving!) business and diversifying your portfolio by tapping into different sectors and industries. Also, stocks that you invest in outside of your retirement portfolio (like in a brokerage account) offer liquidity when you need it. It’s easy to see how tapping into the world of the stock market can be an exhilarating ride. Just don’t forget that amidst the allure, the stock market has a darker side. As much as historic returns can teach us that the stock market is a “safe” bet, it’s possible to lose money. Also, the financial world is not devoid of predators, and names like Enron, Bernie Madoff, and the infamous “Wolf of Wall Street” are cautionary tales that remind us that nothing is ever a “sure bet.” Smart investors will safeguard their financial futures by keeping an eye out for stock market red flags, and arming themselves with knowledge. Here’s a look at some of the most common red flags that should make any stock market investor leery. 

Unrealistic Promises of High Returns

If a company, broker, or advisor claims to guarantee consistent, sky-high profits without risk, that should set off alarm bells.

In finance, high returns often come with high risks. If a prospect sounds too good to be true, it probably is. (And if you’ve got a gut feeling telling you that it is, listen to your instincts!)  Investors should approach any offers for no-risk “guaranteed” returns with skepticism and conduct independent research to verify such claims. Only with thorough research and cautious decision-making can we avoid investment scams.

Overly Aggressive Sales Tactics

High-pressure sales tactics, such as those demanding that you “invest immediately” to take advantage of a “once-in-a-lifetime opportunity” before you miss out, are all-too-common hallmarks of stock scams. (This language should be an immediate red flag for stock market investors.) Legitimate investment opportunities will never require high-pressure sales tactics or instantaneous decisions. 

As an investor, if you encounter a hard sell like this, it’s time to back away. Thoroughly research the investment, ask questions that will help you get to the root of the investment and its longevity, and consult with independent advisors. Remember that hasty decisions can often lead to regrettable consequences. 

Lack of Transparency or Inconsistent Information

In the financial world, transparency is non-negotiable. A company that shies away from providing accurate, comprehensive, and accessible financial data or presents inconsistent, incomplete, or convoluted information raises serious questions.

Investors should conduct thorough due diligence, including reviewing the company’s financial statements, before investing. The absence of clear information is a smokescreen that may hide financial instability or worse — outright fraud.

Excessive Hype and Promotions

In our hyper-connected digital world, hype can spread like wildfire (hello, TikTok) and fraudsters know this too well. In fact, they rely on it. Stocks that are excessively promoted — likely through unsolicited emails, text messages, or social media — merit a more profound investigation.

Heavily promoted stocks may be a sign that you’ve stumbled upon a  “pump and dump” scheme. This is where unscrupulous operators create a buying frenzy by spreading overly optimistic (and frequently false) information to inflate a stock’s price artificially. Once the public has bought in, they then dump their shares at this inflated price for a hefty profit, leaving other investors holding the bag when the stock price inevitably plummets.

Trading on Over-The-Counter (OTC) Markets

You’ve probably heard about over-the-counter (OTC) medicines — but what about OTC stocks? OTC stocks (often called “unlisted” stocks) are those not listed on a national exchange, like the NASDAQ. These stocks are highly risky, and generally trade on Alternative Trading Systems (ATSs). Just how risky? Both the Securities and Exchange Commission (SEC) and The Financial Industry Regulatory Authority (FINRA) have warned against them: “That’s because companies that list OTC aren’t required to file periodic or audited financial reports as they must do if they are listed on a major exchange, such as the NYSE or the Nasdaq. In other words, there’s no way to know if they’re telling the truth when they claim to have sales and profits,” Dan Burrows sums up for Kiplinger

In other words, it’s not the size of the companies that’s the problem — it’s the fact that they aren’t subject to the rigorous scrutiny and regulation as firms listed on more significant exchanges. Furthermore, stocks trading for less than $5, also known as penny stocks, frequently attract the “get rich quick” crowd, who may be less savvy about the risks involved. Such stocks are prime targets for manipulation, underscoring investors’ need to exercise extreme caution.

The journey into the stock market can be exciting, and I believe that every American should invest in order to secure their financial future.  However, it’s crucial not to lose sight of potential red flags amidst the buzz. As you embark on this journey, remember that diligent research can mean the difference between making a profit and suffering a loss. With knowledge and prudence as your allies, you can confidently stride forward as an investor. 


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