Making mistakes is part of the learning process when it comes to investing. However, it’s all too often that plain old common sense separates a successful investor from a poor one. Nearly all investors, whether new or experienced, have gone away from common sense and made a mistake or two over time. Being perfect may be impossible, but knowing some common investing errors can help keep you from going down the well-traveled, yet rocky, path of losses.
Here are seven common stock buying mistakes that can cost investors dearly.
1. Using Too Much Margin
Margin is the use of borrowed money to purchase securities. While margin can help you make more money, it can also exaggerate your losses, making it a definite downside.
The absolute worst thing you can do as a new investor is become carried away with what seems like free money. If you use margin and your investment doesn’t go the way you planned, then you end up with a large debt obligation for nothing. Ask yourself if you would buy stocks with your credit card. Of course you wouldn’t. Using margin excessively is essentially the same thing (albeit likely at a lower interest rate).
Additionally, using margin requires you to monitor your positions much more closely because of the exaggerated gains and losses that accompany small movements in price. If you don’t have the time or knowledge to keep a close eye on and make decisions about your positions and their values drop, then your brokerage firm will sell your stock to recover any losses you have accrued.
As a new investor, use margin sparingly, if at all. Use it only if you understand all its aspects and dangers. It can force you to sell all your positions at the bottom, the point at which you should be in the market for the big turnaround.
2. Buying on Unfounded Tips
Everyone probably makes this mistake at one point or another in their investing career. You may hear your relatives or friends talking about a stock that they heard will get bought out, have killer earnings or soon release a groundbreaking new product. Even if these things are true, they do not necessarily mean that the stock is truly “the next big thing” and that you should rush onto your online brokerage account to place a buy order.
Other unfounded tips come from investment professionals on television and social media who often tout a specific stock as though it’s a must-buy, but really is nothing more than the flavor of the day. These stock tips often don’t pan out and go straight down after you buy them. Remember, buying on media tips is often founded on nothing more than a speculative gamble.
Now this isn’t to say that you should balk at every stock tip. If one really grabs your attention, the first thing to do is consider the source. The next thing is to do your own homework. Make sure you “research, research and research some more” so that you know what you are buying and why. Buying a tech stock with some proprietary technology should be based on whether it’s the right investment for you, not solely on what some mutual fund manager said in a media interview.
Next time you’re tempted to buy based on a hot tip, don’t do so until you’ve got all the facts and are comfortable with the company. Ideally, obtain a second opinion from other investors or unbiased financial advisors.
3. Inexperienced Day Trading
If you insist on becoming an active trader, think twice before day trading. Day trading can be a dangerous game and should be attempted only by the most seasoned investors. In addition to investment savvy, a successful day trader may gain an advantage with access to special equipment that is less readily available to the average trader. Did you know that the average day-trading workstation (with software) can cost in the tens of thousands? You’ll also need a sizable amount of trading money to maintain an efficient day-trading strategy.
The need for speed is the main reason you can’t effectively start day trading with simply the extra $5,000 in your bank account — online brokers do not have systems quite as fast to service the true day trader, so literally the difference of pennies per share can make the difference between a profitable and losing trade. Most brokerages recommend that investors take day trading courses before getting started.
Unless you have the expertise, platform and access to speedy order execution, think twice before day trading. If you aren’t particularly adept at dealing with risk and stress, there are much better options for an investor looking to build wealth.
4. Buying Stocks That Appear Cheap
This is a very common mistake, and those who commit it do so by comparing the current share price with the 52-week high of the stock. Many people using this gauge assume that a fallen share price represents a good buy. But the fact that a company’s share price happened to be 30 percent higher last year will not help it earn more money this year. That’s why it pays to analyze why a stock has fallen.
Deteriorating fundamentals, a CEO resignation or increased competition are all possible reasons for the lower stock price, but they also provide good information to suspect that the stock might not increase anytime soon. A company may be worth less now for fundamental reasons. It is important to always have a critical eye since a low share price might be a false buy signal.
Avoid buying stocks that simply look like a bargain. In many instances, there is a strong fundamental reason for a price decline. Do your homework and analyze a stock’s outlook before you invest in it. You want to invest in companies which will experience sustained growth in the future.
5. Underestimating Your Abilities
Some investors tend to believe they can never excel at investing because stock market success is reserved for sophisticated investors only. This perception has no truth at all. While any commission-based mutual fund salesmen will probably tell you otherwise, most professional money managers don’t make the grade either, with the vast majority underperforming the broad market. With a little time devoted to learning and research, investors can become well-equipped to control their own portfolio and investing decisions, all while being profitable. Remember, much of investing is sticking to common sense and rationality.
Besides having the potential to become sufficiently skillful, individual investors do not face the liquidity challenges and overhead costs large institutional investors do. Any small investor with a sound investment strategy has just as good a chance of beating the market, if not better, than the so-called investment gurus.
Never underestimate your abilities or your own potential. That is, don’t assume you are unable to successfully participate in the financial markets simply because you have a day job.
6. Overlooking the “Big Picture” When Buying a Stock
For a long-term investor, one of the most important but often overlooked things to do is qualitative analysis, or “to look at the big picture.” Legendary investor and author Peter Lynch once stated that he found the best investments by looking at his children’s toys and the trends they would take on. Brand name is also very valuable. Think about how almost everyone in the world knows Coke; the financial value of the name alone is therefore measured in the billions of dollars. Whether it’s about iPhones or Big Macs, no one can argue against real life.
So pouring over financial statements or attempting to identify buy and sell opportunities with complex technical analysis may work a great deal of the time, but if the world is changing against your company, sooner or later you will lose. After all, a typewriter company in the late 1980s could have outperformed any company in its industry, but once personal computers started to become commonplace, an investor in typewriters of that era would have done well to assess the bigger picture and pivot away.
Assessing a company from a qualitative standpoint is as important as looking at the sales and earnings. Qualitative analysis is a strategy that is one of the easiest and most effective for evaluating a potential investment.
7. Compounding Your Losses by Averaging Down
Far too often investors fail to accept the simple fact that they are human and prone to making mistakes just as the greatest investors do. Whether you made a stock purchase in haste or one of your long-time big earners has suddenly taken a turn for the worse, the best thing you can do is accept it. The worst thing you can do is let your pride take priority over your pocketbook and hold on to a losing investment. Or worse yet, buy more shares of the stock since it is much cheaper now.
Remember, a company’s future operating performance has nothing to do with what price you happened to buy its shares at. Anytime there is a sharp decrease in your stock’s price, try to determine the reasons for the change and assess whether the company is a good investment for the future. If not, do your pocketbook a favor and move your money into a company with better prospects.
Letting your pride get in the way of sound investment decisions is foolish and it can decimate your portfolio’s value in a short amount of time. Remain rational and act appropriately when you are inevitably confronted with a loss on what seemed like a rosy investment.
The Bottom Line
With the stock market’s penchant for producing large gains (and losses) there is no shortage of faulty advice and irrational decisions. As an individual investor, the best thing you can do to pad your portfolio for the long term is to implement a rational investment strategy you are comfortable with and willing to stick to.
If you are looking to make a big win by betting your money on your gut feelings, try the casino. Take pride in your investment decisions and in the long run, your portfolio will grow to reflect the soundness of your actions.
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