The advice I hear most often is to stay away from high-priced mutual funds and go for the low cost index funds instead. The logic behind this is that you pay for fund management with no guarantee that the fund will beat its index.
Extending this logic, one might think it would make sense to buy “cheap” stocks. Tons of equities are under $5.00 while some, which may not perform better in the long run, can cost $400 or even $90,000. So if you buy the cheaper stocks, you’re getting a bargain, right?
Not really, according to this article from Investor’s Business Daily. In fact, Nacy Gondo, the author of the article, suggests avoiding cheap stocks. Here are some of her reasons:
Cheap stocks often end up at fire-sale prices for a reason. They may keep missing profit or sales views. They might be the target of a lawsuit or probe. Or they could hail from an ailing industry. Another risk with penny stocks: lower trading volume. Mutual funds and other big investors are less likely to buy cheap stocks, since they can’t take big stakes without drastically moving the stock price.
It seems to me that when it comes to stocks, the absolute price of a share should not be the main factor when deciding what companies are the best for investing. A better indicator of “cheap vs. expensive” would be the price-to-earnings (P/E) ratio and how it compares among similar companies. A lower relative P/E ratio likely denotes the better buy, barring any abdormal circumstances.
Updated July 16, 2010 and originally published November 8, 2005. If you enjoyed this article, subscribe to the RSS feed or receive daily emails. Follow @flexo on Twitter and visit our Facebook page for more updates.