Thanks to online discount brokerages, anyone with an Internet connection and a bank account can be up and trading stocks within a week. This ease of access is great because it encourages more people to explore investing for themselves, rather than depending on mutual funds or money managers. However, 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

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 is low and what is high in a market where everything hinges on different readings of a variety of ratios and metrics. 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 market 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, and understand how they are calculated and where their major weaknesses lie. While you are learning, you can see how your conclusions work 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.)

Playing Penny Stocks
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, if the two blue chip shares you bought went up $1 you'd only make $2, whereas if 100 shares of a $1 stock went up a $1 you would double your money. Unfortunately, what penny stocks offer in position size and potential profitability has to measure against the volatility that they face. Penny stocks can shoot up. It happens all the time - but they can also crash in moments, and 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.)

Going All In with One Investment
Investing 100% of your capital in a specific market, whether it is the stock market, commodity futures, forex or even bonds is not a good move. Although you may eventually decide to throw diversification to the wind and put all your available capital into these markets once you are familiar with them, it is better to risk a little bit of capital at a time. 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.)

Leveraging Up
Leveraging your money by using a margin is similar to going all in, but much more damaging. Using leverage magnifies both the gains and the losses on a given investment. Some forms of leverage, such as options, have a limited downside or can be controlled by using specific market orders, as in forex. 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.)

Investing Cash Reserves
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 to the point of illiquidity. 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. (To learn more about liquidity's importance, read Understanding Financial Liquidity.)

Chasing News
Trying to guess what will be the next "Apple," a revolutionary produce or a rumor of earth shaking earnings, investing on news is a terrible move for first time investors. 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 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. This connection makes it easier to stomach the time and research that investing demands. (For more on the psychology of trading, read How The Power Of The Masses Drives The Market.)

The Bottom Line
When you are starting to invest, it is best to start small and take the risks with money you are prepared to lose. As you gain confidence and become more adept at evaluating stocks and reading the market sentiment, you can start making bigger investments. None of these investments are bad in and of themselves, but they do tend to be very unforgiving towards rookie mistakes. Leverage, penny stocks, news trading, etc. can all become part of your investing strategy as you learn, should you choose it. The trick is learning to invest in more stable markets before you jump into the wilder areas.

Related Articles
  1. Options & Futures

    Shopping For A Financial Advisor

    Finding your perfect advisor is as simple as shopping for a car. Read on to learn more.
  2. Investing Basics

    Buy-And-Hold Investing Vs. Market Timing

    If volatility and emotion are removed, passive, long-term investing comes out on top.
  3. Active Trading

    Understanding Liquidity Risk

    Make sure that your trades are safe by learning how to measure the liquidity risk.
  4. Markets

    Book Value: How Reliable Is It For Investors?

    In theory, a low P/B ratio means you have a cushion against poor performance. In practice, it is much less certain.
  5. Forex Education

    Forex Investing: How To Capture Commodity Fluctuations

    For individual or retail investors looking to gain exposure to hot commodity trends, the foreign exchange markets provide the answer.
  6. Economics

    Financial Media 4-1-1 For Investors

    Cut through the information clutter and decipher the useful news from the useless.
  7. Trading Strategies

    Who Actually Trades or Invests In Penny Stocks?

    Although penny stocks are highly speculative, millions of people trade them daily. Here are 10 different types who do.
  8. Investing Basics

    Why do Debt to Equity Ratios Vary From Industry to Industry?

    Obtain a better understanding of the debt/equity ratio, and learn why this fundamental financial metric varies significantly between industries.
  9. Mutual Funds & ETFs

    Top 5 Chinese Mutual Funds

    Learn about some of the most popular and best performing mutual funds that offer investors exposure to the important emerging market economy of China.
  10. Investing Basics

    Explaining Unrealized Gain

    An unrealized gain occurs when the current price of a security exceeds the price an investor paid for the security.
RELATED TERMS
  1. Equity

    The value of an asset less the value of all liabilities on that ...
  2. Exchange-Traded Fund (ETF)

    A security that tracks an index, a commodity or a basket of assets ...
  3. Debt/Equity Ratio

    1. A debt ratio used to measure a company's financial leverage. ...
  4. Compound Annual Growth Rate - CAGR

    The Compound Annual Growth Rate (CAGR) is the mean annual growth ...
  5. Return On Investment - ROI

    A performance measure used to evaluate the efficiency of an investment ...
  6. Systematic Manager

    A manager who adjusts a portfolio’s long and short-term positions ...
RELATED FAQS
  1. Do penny stocks pay dividends?

    Because of the small market capitalization and revenues typical of most penny stocks, there are very few that offer dividends. ... Read Full Answer >>
  2. Can you buy penny stocks in an IRA?

    It is possible to trade penny stocks through an individual retirement accounts, or IRA. However, penny stocks are generally ... Read Full Answer >>
  3. Where do penny stocks trade?

    Generally, penny stocks are traded through the use of the Over the Counter Bulletin Board (OTCBB) and through pink sheets. ... Read Full Answer >>
  4. Where can I buy penny stocks?

    Some penny stocks, those using the definition of trading for less than $5 per share, are traded on regular exchanges such ... Read Full Answer >>
  5. What is a stock split? Why do stocks split?

    All publicly-traded companies have a set number of shares that are outstanding on the stock market. A stock split is a decision ... Read Full Answer >>
  6. Is there a difference between financial spread betting and arbitrage?

    Financial spread betting is a type of speculation that involves a highly leveraged derivative product, whereas arbitrage ... Read Full Answer >>

You May Also Like

Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!