Investing in stocks can be a fantastic way to build wealth, but it can also be expensive. Some stocks cost several hundred or even thousands of dollars per share, which is out of many investors' budgets.
For example, Tesla (NASDAQ: TSLA) is trading for nearly $700 per share at the time of this writing. Building a well-diversified portfolio requires investing in at least 10 to 15 different stocks. If you're paying hundreds of dollars per share, you can easily spend thousands of dollars just getting started in the stock market.
If you're trying to invest on a budget, it may be tempting to opt for penny stocks. Penny stocks are very inexpensive investments, often trading for $1 or less per share. However, these stocks can be incredibly risky, and there's a much better alternative.
Why avoid penny stocks
Penny stocks are attractive because of their low price. If you can't afford to invest thousands of dollars building a diversified portfolio, it may seem like penny stocks are your best option.
While they are more affordable than traditional stocks, they carry far more risk.
Penny stocks are normally issued by small companies that don't have a long history (or their financial information is not accessible to the public). That makes it hard to research these stocks to determine whether they're solid investments.
Also, penny stock prices are subject to extreme price swings. That risk is exacerbated by the fact that these stocks are often harder to sell.
Say, for example, you buy 100 shares of a penny stock for $1 per share. Now let's say that tomorrow, the stock price drops to $0.90 per share. You start to get worried and want to sell. But nobody is buying right now, so you're stuck with your stock. By the time you're able to sell, the price has dropped to $0.50 per share, and you've sold your shares for half of what you paid for them.
It's possible to make a lot of money with penny stocks, but the risks often outweigh the rewards. For that reason, penny stocks are best left to investors with deep pockets and an extremely high tolerance for risk. For everyone else, there's a better investment: fractional shares.
Why invest in fractional shares
As the name suggests, investing in fractional shares involves buying just a fraction of an individual share of stock. Full shares of stock can trade for hundreds or thousands of dollars. But by buying fractional shares, you can buy that same stock for a fraction of the price.
For example, say you want to invest in Tesla but can't afford the nearly $700-per-share stock price. If you invest in a fractional share of the stock, you can buy Tesla for as little as $1.
Fractional shares are a fantastic way to invest in individual stocks without breaking the bank. Unlike penny stocks, you're still investing in big-name stocks — just at a lower price. That limits your risk because larger, more established companies tend to be less volatile than small businesses.
It's also much more affordable to build a diversified portfolio. Rather than spending thousands of dollars buying a dozen or so full shares of stocks, you can create your portfolio for $100 or less.
Finally, keep in mind that it's still crucial to do your research before you invest. Just because you can buy a stock for a couple of dollars doesn't mean it's a good investment, and you could run into trouble down the road.
For instance, if you buy a fractional share of stock for $1 and it performs well in the short term, you may be tempted to invest another $100, then $500, then $1,000. But if that company has weak fundamentals, it's unlikely to succeed over the long run and you could lose a lot of money. Doing your research from the start could save you money over time.
Investing can be expensive, but it doesn't have to break the bank. Fractional shares are a smart way to buy solid companies at low prices, making it easier to invest even if you're on a tight budget.
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Katie Brockman has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Tesla. The Motley Fool has a disclosure policy.