There are some common mistakes that first time investors have to be aware of before they try picking stocks like Buffett or shorting like Soros. (To learn more, see Billionaire Portfolios: What Are They Hiding?)
TUTORIAL: 20 Investments To Know
1. Jumping in Head First
The basics of investing are quite simple in theory – buy low and sell high. In practice, however, you have to know what “low” and “high” really mean.
What is “high” to the seller is considered “low” (enough) to the buyer in any transaction, so you can see how different conclusions can be drawn from the same information. Because of the relative nature of the market, it is important to study up a bit before jumping in. (To learn more, see Stochastics: An Accurate Buy And Sell Indicator.)
At the very least, know the basic metrics such as book value, dividend yield, price-earnings ratio (P/E) and so on. Understand how they are calculated, where their major weaknesses lie and where these metrics have generally been for a stock and its industry over time.
While you are learning, it’s always good to start out by using virtual money in a stock simulator. Most likely, you'll find that the market is much more complex than a few ratios can express, but learning those and testing them on a demo account can help lead you to the next level of study. (Watching metrics like book value and P/E are crucial to value investing. Get acquainted with 5 Must-Have Metrics for Value Investing.)
2. Playing Penny Stocks and Fads
At first glance, penny stocks seem like a great idea. With as little as $100, you can get a lot more shares in a penny stock than a blue chip that might cost $50 a share. And, you have a lot more upside if a penny stock goes up by a dollar.
Unfortunately, what penny stocks offer in position size and potential profitability has to measure against the volatility that they face. Penny stocks are penny stocks for a reason – they are poor quality companies that, more often than not, will not work out profitability. And, losing $0.5 on a penny stock could mean a 100% loss.
Penny stocks are exceptionally vulnerable to manipulation and illiquidity. Getting solid information on penny stocks can also be difficult, making them a poor choice for an investor who is still learning. (To learn more, read The Lowdown On Penny Stocks.)
Overall, remember to think about stocks in percentages and not whole dollar amounts. And you’d probably prefer to own a quality stock for a long time than trying to make a quick buck on a low-quality company (except for professionals, most of the returns on penny stocks can be drilled down to luck).
3. Going All in With One Investment
Investing 100% of your capital in a specific investment is usually not a good move (even 100% in a specific commodity futures, forex or bonds). Any company, even the best ones, can have issues and see their stocks decline dramatically.
You have a lot more upside by deciding to throw diversification to the wind, but you also have a lot more risk. Especially as a first-time investor, it’s good to buy at least a handful of stocks. This way, the lessons learned along the way are less costly, but still valuable. (Diversification entails calculating correlation, learn more about it by reading Diversification: Protecting Portfolios From Mass Destruction.)
4. Leveraging Up
Take this example – you have $100 and borrow $50 to buy $150 of a stock. If the stock rises 10%, you make $15, or a 15% return on your capital. But, if the stock declines 10%, you lose $15, or a 15% loss. More importantly, if the stock goes up by 50%, you make 75% return. But, if the stock declines 50%, you lose all the money you borrowed and more.
There are other forms of leverage besides borrowing money, such as options, which can have a limited downside or can be controlled by using specific market orders, as in forex. But these can be complex instruments that you should only use once you have a full grasp of the market.
Learning to control the amount of capital at risk comes with practice, and until an investor learns that control, leverage is best taken in small doses (if at all). (Read more with Leverage's "Double-Edged Sword" Need Not Cut Deep.)
5. Investing Cash You Can’t Afford to Lose
Studies have shown that cash put into the market in bulk rather than incrementally has a better overall return, but this doesn't mean you should invest your whole nest egg at one time. Investing is a long-term business whether you are a buy-and-hold investor or a trader, and staying in business requires having cash on the sidelines for emergencies and opportunities. Sure, cash on the sidelines doesn't earn any returns, but having all your cash in the market is a risk that even professional investors won't take.
If you only have enough cash to invest or have an emergency cash reserve, then you're not in a position financially where investing makes sense. This kind of investing leads to making mistakes due to your behavioral biases, and there more than enough mistakes you can make in the market without having those in play. (To learn more about liquidity's importance, read Understanding Financial Liquidity.)
6. Chasing News
Whether it’s trying to guess what will be the next "Apple," investing quickly in a “hot” stock tip, or going all-in on a rumor of earth-shaking earnings, investing on news is a terrible move for first time investors. Remember, you are competing with professional firms that not only get information the second it becomes available, but also know how to properly analyze it quickly.
The best case scenario is that you get lucky and then keep doing it until your luck fails. The worst case scenario is that you get stuck jumping in late (or investing based on the wrong rumor) time and time again before you give up on investing.
Rather than following rumors, the ideal first investments are in companies you understand and have a personal experience dealing with. You wouldn’t keep betting on black at a casino to make long-term profits, so you shouldn’t do what is the investing equivalent. (For more on the psychology of trading, read How The Power Of The Masses Drives The Market.)
The Bottom Line
Remember, when you are personally buying stocks in the market, you are competing against large mutual funds and institutional investors that not only do this full-time, they also do this with far more resources and in-depth information than the average person has. When you are starting to invest, it is best to start small and take the risks with money you are prepared to lose – the market can be unforgiving to rookie mistakes. As you become more adept at evaluating stocks, you can start making bigger investments.
It’s good to invest on your own and learn more about the markets. But, invest in things you know, and always have a bias for quality stocks that you want to hold for long periods of time. It sounds attractive to try and make a quick buck, but like anything else, real money is made by slowly compounding your returns.