Ignorance may be bliss, but not knowing why your stocks are failing and money is disappearing from your pockets is a long way from paradise. In this article, we'll uncover some of the more common investing faux pas, as well as provide you with suggestions on how to avoid them.
Tutorial: Major Investment Industries
1. Ignoring Catalysts
The financial pundits, trade journals and business schools teach that proper valuation is the key to stock selection. This is only half of the picture because calculating P/E ratios and running cash flow spreadsheets can only show where a company is at a given point in time - it cannot tell us where it is heading.
Some good questions to ask yourself include:
- Is the company about to acquire a very profitable enterprise?
- Is a potential blockbuster product about to be launched?
- Are economies of scale being realized at the company's new plant and are margins about to rise dramatically?
- What will drive earnings and the stock price going forward?
2. Catching the Falling Knife
Investors love to buy companies on the cheap, but far too often, investors buy in before all of the bad news is out in the public domain, and/or before the stock stops its free fall. Remember, new lows in a company's share price often beget further new lows as investors see the shares dropping, become disheartened and then sell their shares. Waiting until the selling pressure has subsided is almost always your best bet to avoid getting cut on a falling knife stock. (To learn more, read How Investors Often Cause The Market's Problems.)
3. Failing to Consider Macroeconomic Variables
You have found a company you want to invest in. Its valuation is superior to that of its peers. It has several new products that are about to be launched, and sales could skyrocket. Even the insiders are buying the stock, which bolsters your confidence all the more.
But if you haven't considered the current macroeconomic conditions, such as unemployment and inflation, and how they might impact the sector you are invested in, you've made a fatal mistake!
Keep in mind that a retailer or electronics manufacturer is subject to a number of factors beyond its control that could adversely impact the share price. Things to consider are oil prices, labor costs, scarcity of raw materials, strikes, interest rate fluctuations and consumer spending. (For more on these factors, see Macroeconomic Analysis and Where Top Down Meets Bottom Up.)
4. Forgetting About Dilution
Be on the lookout for companies that are continuously issuing millions of shares and causing dilution, or those that have issued convertible debt. Convertible debt may be converted by the holder into common shares at a set price. Conversion will result in a lower value of holdings for existing shareholders.
A better idea is to seek companies that are repurchasing stock and therefore reducing the number of shares outstanding. This process increases earnings per share (EPS) and it tells investors that the company feels that there is no better investment than their own company at the moment. (You can read more about buybacks in A Breakdown Of Stock Buybacks.)
5. Not Recognizing Seasonal Fluctuations
You can't fight the Fed. By that same token, you can't expect that your shares will appreciate even if the company's shares are widely traded in high volumes. The fact is that many companies (such as retailers) go through boom and bust cycles year in and year out. Luckily, these cycles are fairly predictable, so do yourself a favor and look at a five-year chart before buying shares in a company. Does the stock typically wane during a particular part of the year and then pick up during others? If so, consider timing your purchase or sale accordingly. (To learn more, see Capitalizing On Seasonal Effects.)
6. Missing Sector Trends
Some stocks do buck the larger trend; however, this behavior usually occurs because there is some huge catalyst that propels the stock either higher or lower. For the most part, companies trade in relative parity to their peers. This keeps their stock price movements within a trading band or range. Keep this in mind as you consider your entry/exit points in a stock.
Also, if you own stock in a semiconductor company (for example), understand that if other semiconductor companies are experiencing certain problems, your company will too. The same is true if the situation was reversed, and positive news hit the industry.
7. Avoiding Technical Trends
Many people shy away from technical analysis, but you don't have to be a chartist to be able to identify certain technical trends. A simple graph depicting 50-day and 200-day moving averages as well as daily closing prices can give investors a good picture of where a stock is headed. (To learn about this method, read the Basics Of Technical Analysis.)
Be wary of companies that trade and/or close below those averages. It usually means the shares will go lower. The same can be said to the upside. Also remember that as volume trails off, the stock price typically follows suit.
Lastly, look for general trends. Has the stock been under accumulation or distribution over the past year? In other words, is the price gradually moving up, or down? This is simple information that can be gleaned from a chart. It is truly surprising that most investors don't take advantage of these simple and accessible tools.
The Bottom line
There are a myriad of mistakes that investors can and do make. These are simply some of the more common ones. In any case, it pays to think about factors beyond what will propel the stock you own higher. A stock's past and expected performance in comparison to its peers, as well as its performance when subjected to economic conditions that may impact the company, are some other factors to consider.
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