Many investors are often left scratching their heads on how to strike it rich in the stock market. However, we can view this from another angle just by flipping the question around. That is, how do we not lose money in the stock market? This also ties in with a famous rule Warren Buffett lives by: “Rule Number 1: Never lose money. Rule Number 2: Don’t forget rule number 1.”
So, here are 3 ways which would make investors lose money if they do not have a good grasp of the pitfalls lying in wait.
1. Buying companies purely based on stock tips
There will be occasions when well-intentioned people close to you give stock tips. These can happen anytime in the normal course of the day. It could be at the dinner table with your family and friends when the topic of stock investing is broached. Or it could be during a taxi ride when you meet a chatty driver.
“Hey, did you read the news on stock X, it has already gone up from $1 to $5 and if “insert event/trend here” happens, it will surely go up to $50.”
“My friend who knows a fund manager at a reputable equities firm recommended these stocks. Take a look at them. Time is running out because the prices will be going to the moon soon.”
Think about it. Has this happened to you before? Does hearing that a stock will go up by many times make your pulse go racing? And it keeps lingering and you feel you have no choice but to purchase the stock? This is normal human nature but still, we should be cognizant of our psychological biases and think rationally.
Daniel Kahneman, a renowned psychologist known for penning the standout book “Thinking Fast and Slow” muses that we have 2 thinking systems: system 1 which thinks fast, and system 2, the slow and logical thinker. Whenever we sense potential danger or for that matter, a share price surge, without thinking, our emotions of greed and fear of missing out immediately set in. We start to envision the things we could do with the gains when that happens. With that, we also think about what we will miss out on if we don’t follow the stock tip. That is system 1, the automatic mode.
If we do not allow system 2 to kick in and think rationally, we will not know whether this is real or just another plot conceived to say goodbye to our money. We do not perform any due diligence and will not hesitate to wallop our money in. The outcome will be disastrous, to say the least.
2. Buying companies (you think) you know very well
This should come as a surprise. You must be thinking stock investing is already a crazy-enough activity to partake in. So all the more we should reduce our risk by buying companies we know well or use their products regularly. Sometimes we even choose to buy an interest in the companies we work in which are listed in the stock market.
However, these are times when being overconfident can work against us. We plonk all our money into these companies because we feel we know them so well that they cannot possibly fail. Or for that matter, even if the company were to underperform, we would have first-hand information and can dispose of it earlier than the general market.
“I know the CEO or Chairman of the company very well. The CEO or Chairman is a superb person. Very good foresight, honest, and good with money, etc.”
“I like using this company’s products. I don’t mind paying a premium for them because they provide so much convenience to me. Therefore, I am buying some shares because they are definitely going to sell well, for sure.”
Due to this, we also do not consider other viable alternatives in the market. We tell ourselves it is too risky to do so. And that it does not make sense to buy other companies we know little of. Granted, it is also true we should invest within our circle of competence. But we should also be aware of the limitations in investing. What we know is important, so is what we don’t know.
We should not be blindsided and fail to ask the questions that matter as we turn a blind eye to other factors which require further scrutinizing.
3. Buying companies with no growth prospects
You might ask so what makes a share price move north. For that to happen, you need a lot of other investors to believe in the company and its growth. Once the belief is instilled and concrete, then the share price will follow and rise. But what gives them the belief? If you are thinking, “the investors feel that company will perform better and its profits and cash flow will grow every year”, yes, you are right.
More often than not, we do not use this as our criteria. As was put forth earlier in points one and two above, we do not think rationally enough at times and follow the fad happening around us; we also buy what is familiar to us but we do not look closely at how and why the company’s profitability will grow in the future.
Whenever we are analyzing a company, we need to discern what are the growth prospects of the company. What is it about the company and its management which will enable it to keep growing revenues and profits? Is the management innovative enough to find more market opportunities or create more optionalities for the company? For the products/services it is offering now, is there a long runway ahead for it to grow and become more successful?
As mentioned above in point 2, investors find it risky to invest in companies outside their circle of competence. As such, they stick to what they are comfortable with which may not have good growth prospects. This should be construed as a bigger risk in fact. As stale or deteriorating results would lead to declining share performance.
So there you have it, the above are three things to ponder when we participate in the game of share investing. Do any of these resonate with you? If so, we should always keep a lookout for such situations and endeavor not to fall into a trap we create ourselves.