When learning any skill, it is best to start young. Investing is no different. Mistakes are common when learning something new, but when dealing with money, there can be serious consequences.
Investors who start young generally have the time to take on risks and recover from their money-losing errors, but avoiding the following common mistakes can help improve the odds of success.
No. 1: Trading too frequently
It is easy to find yourself trading too often when you are just starting. At first, you would buy into a handful of exciting companies … only to discover some other interesting opportunities, so you sell some shares of the first batch of companies and buy into some others. Not only is this a good way to rack up trading fees, but it may also cost you more in taxes.
But beyond that, you need to give your investments time to grow — ideally, many years. And if you find yourself losing confidence in the stocks you buy, that could be a sign you are not studying them enough before you buy.
No. 2: Buying penny stocks
Penny stocks are high-risk securities with a small market capitalization that trade for a relatively low share price, typically outside the major exchanges. Young investors are often attracted to penny stocks as they believe there is more room for appreciation and more opportunity to own more shares.
But the trouble is that penny stocks are often tied to unproven, unprofitable, and sometimes shady companies. They are also frequently illiquid, very volatile and easily manipulated by scammers.
Scammers will buy shares of such penny stocks, hype it up online or in newsletters so that others buy-in and drive up the price — and then the scammers sell their shares, causing the price to plunge, leaving the other investors with big losses. That is called a “pump-and-dump” scheme.
No. 3: Speculating instead of investing
A young investor tends to seek out bigger returns by taking risks, believing they have time to recover the losses through income generation. But gambling on highly speculative trades can result in a large loss that can scar a young investor and affect his or her future investment choice. This can lead to a tendency to shun investing altogether or to move to lower or risk-free assets at an age when it may not be appropriate.
Instead of gambling or taking on highly speculative trades, a young investor can consider investing as an alternative approach to speculation. Before you buy a stock, find out everything you can about the company, its management and competitors, its earnings and possibilities for growth. By doing your research and valuation work, relying on critical thinking, and questioning conventional wisdom, you should be able to make smarter investment decisions.
No. 4: Investing with borrowed money
Young investors can get easily excited about the prospect of investing with borrowed money or “margin”. Here is why: imagine that you invest $10,000 in stock and it gains 50%, you now have a stock that is worth $15,000. But let us say you had borrowed $10,000 and invested $20,000 in stock, then you could have $30,000!
Using margin is perfectly legal and can greatly amplify your gains — but it can also amplify your losses. In the example above, if the stock you borrowed money to buy falls by 50%, your $20,000 stake in it will be worth $10,000 — the sum you borrowed. Once you pay back the loan, you would be left with $0 — meaning that a 50% loss now became a 100% loss, thanks to margin. Not forgetting that brokerages charge you interest for the margin. Hence you would need to earn an even higher return to make the borrowing worthwhile.
Furthermore, the equity in your account is the collateral that you are putting up for the loan. If the value of your investments made on margin start falling significantly, you may get a “margin call” from your broker asking you to sell some assets to generate cash or to deposit more cash into your account. If you fail to do so, the brokerage may sell some of your stock holdings (even at a loss) for you. Margin is best avoided, for most investors.
No. 5: Buying and selling based on emotions
Too many new investors (and many seasoned ones too) have a knack for piling into investments at market tops and selling at the markets bottoms. They buy shares of companies based on excitement and greed, with insufficient attention paid to how undervalued or overvalued the stocks are. They also sell in a panic if the overall market drops or if one or more of their stocks declines sharply.
The good news is that investors can overcome emotional investing by focusing on what is important: buying and holding a diverse portfolio of high-quality companies. Do not buy and sell based on the stock price; instead, look at how the business behind the stock is performing. Daily, the stock market can seem like a casino, but over time stock prices will reflect the quality of the businesses they represent.
No. 6: Not evaluating your performance
As investors, we should be assessing our performance regularly. If we are investing in individual stocks, it makes sense to aim to outperform the index. If we cannot consistently beat the index over years, the money may be better kept in a low-cost index fund.
Do not throw in the towel after just a single year (or maybe two) of underperformance, though, but try to assess how well you are doing over a few years. If you keep reading and learning about investing, you may refine your strategies for the better over time.