It is easy for a beginning investor to make mistakes out of exuberance, impatience, or even ignorance. But those mistakes can be costly, making them worth avoiding.
As you find your feet as a new investor, this article can give you a better idea of what kind of temperament you will need, what expectations are reasonable to have, and what strategies will serve you best. Here are 7 common beginner-investor mistakes – and how to avoid them.
No. 1: Investing before you are ready
First, never invest until you are ready to, and that means financially, as well as mentally.
- Pay off your high-interest-rate debt before you start investing. If you are deep in debt and paying, say, 15% in interest annually (which is not an unusual rate), any money you invest in stocks (instead of paying off the debt) would have to earn more than 15%, just to keep you from losing ground. Therefore, paring down the debt may be wise if you are unable to generate an equivalent or higher return from the stock market.
- It is also smart to have 6 to 12 months’ worth of living expenses stocked in an emergency fund before you start putting money into stocks. Without an emergency fund, you may be forced to sell your stocks to raise funds due to an unexpected medical bill or expensive car repair. Avoid having to sell your stocks at an inopportune time – such as a temporary downturn in stock prices – as this may result in permanent capital loss.
No. 2: Setting unrealistic expectations
Building wealth through the stock market takes time. Therefore, it is important not to have unrealistic dreams of becoming an instant stock market millionaire. As a new investor, you should know that the stock market’s long-term average annual return is close to 10%, but some years it can surge and drop by 20% or more. Accept that volatility is a feature of the stock market, and be prepared to handle the inevitable ups and downs in the overall market.
Also, never put any money into stocks that you may need within the next five years as the stock market swoons occasionally and stock prices may take a few years to recover. Be patient, and do your best not to interrupt the compounding process unnecessarily. Warren Buffet puts it succinctly: “The stock market is a device for transferring money from the impatient to the patient”.
No. 3: Trusting the wrong people or sources
Many new investors put too much faith in hot stocks tips offered by a friend or colleague, their stockbroker or even talking heads on financial TV programmes. And they act on the investment advice rarely knowing the track record of the recommender.
Know that anyone can give investment advice – but even great investors will make mistakes. Hence, it is important that you do your own research before putting money into any investment. Do your homework so that you are not fleeced by so-called advisers to put money into a one-of-a-kind, sure-win investment. Remember, anything that sounds too good to be true most likely is.
No. 4: Buying into investments you do not understand
Before you invest in any stock, you really need to have a good understanding on exactly how the company makes its money, what its competitive advantages and risks are, how financially healthy it is (cash vs debt position), and how rosy its future prospects seem to be. Considering this, companies in industries such as retail and consumer goods can be easier to understand than others, such as oil and gas or financial services.
As new investors, you do not necessarily need to understand these more obscure areas (such as biotechnology or renewable energy) to invest capital. Far more important is to honestly define what you do know and stick to those areas. Your circle of competence can be widened, but only slowly and over time. Mistakes are most often made when straying from this discipline.
No. 5: Not diversifying sufficiently
Not diversifying enough is a common investing mistake made by new investors. Diversifying your stock portfolio is important because it keeps any part of your investment assets from being too heavily weighted towards one company or sector.
If all your money is in just one stock, and that stock doubles, your portfolio doubles! But if that stock drops by 50%, so does your whole portfolio. While there is no perfect number of stocks to own, for many investors, a portfolio of 15-20 stocks is a reasonable number.
Also, aim to be invested in a range of industries that you understand. Investors who loaded up on tech stocks in 2000 lost their shirts when the dot-com bubble burst and technology shares rapidly fell out of flavour. Similarly, financial stocks were hammered down in late 2007 and early 2008 due to the subprime mortgage crisis. Anyone exclusively invested in these single sectors at those times would have experienced significant losses.
No. 6: Not selling a bad stock or waiting for an unlikely rebound
What would you do in this situation: You bought shares of a stock a while ago on a stock tip (bad idea as explained above), and they have dropped in value. Let us say that you bought 100 shares at $50 apiece, for $5,000, and now the stock is only at $30 and your investment is worth just $3,000. Should you sell or keep the shares?
Many investors in this scenario would stubbornly hang on, not wanting to realise the $2,000 loss. They hope that the shares can recover at least enough to break even – and then they will sell and move the money elsewhere. But is that a smart move if the rationale for buying the stock was flawed in the first place?
Yes, it feels awful to make a mistake – but it happens. If you have lost confidence in an investment, it is always better to sell the shares, take your loss, and move the remaining $3,000 into a stock in which has better prospects. Your money is more likely to grow in value there, and you might be able to make up the loss of $2,000 in this more promising company.
No. 7: Trying to time the market
Lastly, many new investors try to engage in market timing — – they attempt to get in and out of the market based on whether they think the stock market is heading up or down. Such actions may seem reasonable, especially if you listen to so-called financial TV experts who say they can predict where the stock market is headed in the near future. But in reality, timing the market is a fool-hardy exercise, and guessing wrong can cost you dearly.
Consider that researchers at Morningstar.com found that over the 20 years from 1992 to 2011, the U.S. stock market averaged 7.8% annually. If you were out of the market on the 10 worst days in that period, you would have averaged 12%, while if you were out during the 10 best days, you’d have averaged 4.1%.
Index-fund pioneer John Bogle has quipped: “Sure, it’d be great to get out of stocks at the high and jump back in at the low, [but] in 55 years in the business, I not only have never met anybody who knew how to do it, I have never met anybody who had met anybody who knew how to do it.”