Meme stocks: What are they and why you should be careful buying them

There's a good chance you have seen the term "meme stock" splashed across headlines in the past year — even if you aren't actively following business news.

The meme stock craze, driven largely by investors on social media platforms and in online forums like Reddit, caused certain stocks to go viral. Perhaps the most famous was the WallStreetBets Reddit thread that encouraged people to buy GameStop and AMC Entertainment stock at the beginning of 2021.

But what is a meme stock exactly?

Meme stocks refer to a select few stocks that gain sudden popularity on the internet and lead to sky-high prices and unusually high trading volume. While some Reddit traders were able to make a lot of money in a short amount of time by buying and then selling AMC and/or GameStop at the exact right moment, investing in meme stocks is generally very risky.

A meme stock's value is a result of its hype on social media and not necessarily the company's performance. Though there is a potential for monumental gains, meme investors are more likely to experience potentially bigger losses as the stocks become overvalued and their price dramatically plummets.

Though the idea of amassing crazy wealth overnight is obviously appealing, the reality is that the odds are heavily stacked against anyone trying to outsmart the market. The meme investors who walked away with a lot of money were arguably just very lucky. This kind of trading is ultimately not that much different than gambling.

Instead of actively trying to find the next hot stock, you're better off with a more hands-off approach of index investing. Unlike individual stocks, index investing offers automatic diversification that spreads out your risk so you don't have to worry that you'll lose all your money with one bad trade. (Of course, all investing involves some amount of risk.)

How to invest in an index fund

To invest in an index fund, you need to open a brokerage account, a traditional IRA or a Roth IRA. You can often choose to invest in index funds via your employer-sponsored 401(k), too.

A broker like Vanguard is a good choice for passive investors who want to hold funds long-term as it doesn't offer many tools for those who are more active traders or interested in short-term trading. Vanguard also stands out for its low costs. Expense ratios (basically the management costs) for its ETFs and mutual funds are some of the lowest around, with an average of 0.10%, meaning every $10,000 invested costs $10 annually.

Once your account is open and funded, you can also choose from a number of different index funds, like an S&P 500 fund, a fund that tracks government bonds or a fund that tracks international stocks. Funds that track the S&P 500 are generally an effective way to earn a good return on your money over time. Historically, the average annual return for the S&P 500 hovers around 10%. Of course, past returns do not guarantee future gains.

Charles Schwab's S&P 500 Index Fund (SWPPX) is a straightforward option with no investment minimum. Its expense ratio is 0.02%, meaning every $10,000 invested costs $2 annually.

For an option with no expense ratio whatsoever, consider the Fidelity ZERO Large Cap Index (FNILX). Though the fund doesn't technically track the S&P 500, the Fidelity U.S. Large Cap Index tracks large capitalization stocks, which the website says, "are considered to be stocks of the largest 500 U.S. companies."

For those still itching to trade the next viral stock, invest only with money you can afford to lose. Before you invest, you should make sure you already have an emergency fund set aside, you've paid off your high-interest debt and you're already contributing to a retirement account (and meeting any 401(k) employer match, if applicable).

When you're ready to buy stocks, your first need to open a taxable brokerage account. Robinhood and Webull are two popular trading platforms for active investors, boasting easy-to-use mobile investing apps. Plus, they offer IRAs (traditional, Roth and rollover) so users can manage their retirement funds along with their stocks all in one place.

Both companies also allow investor to buy fractional shares of stocks, so you can buy a piece of the action without getting in too deep. Experts generally suggest keeping individual stock picking limited to 5% to 10% of your overall investment portfolio.

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