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. We'll uncover some of the more common investing faux pas, as well as provide you with suggestions on how to avoid them.
Mistake No.1 - Ignoring Catalysts
Proper valuation, calculating P/E ratios, and running cash flow spreadsheets gives only half of the picture when selecting a stock. These can only show where a company is at a given point in time - not where it is heading.
Therefore, in addition to a quantitative evaluation of a company, you must also do a qualitative study so that you can determine which catalysts will drive earnings going forward.
- Is a potential blockbuster product about to be launched?
- Are economies of scale being realized and are margins about to rise dramatically?
- What will drive earnings and the stock price going forward?
Mistake No.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, they 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.)
Mistake No.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, you've made a fatal mistake. Make sure to also consider 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.)
Mistake No.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.
Try seeking companies that are repurchasing stock and therefore reducing the number of shares outstanding. This process increases earnings per share (EPS) but it also tells investors that the company feels that there is no better investment than their own company at the moment. (You can read more in A Breakdown Of Stock Buybacks.)
Mistake No.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 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.)
Mistake No.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.
For example, if you own stock in a semiconductor company, 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.
Mistake No.7 - Avoiding Technical Trends
You don't have to be a chartist to be able to perform technical analysis. A simple graph depicting 50-day and 200-day moving averages (MA) as well as daily closing prices can give investors a good picture of where a stock is headed. (Learn more in the Basics Of Technical Analysis.)
Be wary of stocks 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, so does the stock price.
Lastly, look for general trends. In other words, is the price gradually moving up, or down? Use these simple and accessible tools before making a pick.
There are a myriad of mistakes that investors can and do make. These are some of the more common ones. In any case, it pays to think about factors beyond what will propel the stock you own higher. Some factors that may impact a company is a stock's past and expected performance in comparison to its peers, as well as its performance when subjected to certain economic conditions.