The Cardinal Sin Of Beginning Investing -- And How To Avoid It

By StreetAuthority | January 22, 2013 AAA

Each week, one of our investing experts answers a reader's question in the Q&A column from our sister site, InvestingAnswers.com. It's all part of our mission to help consumers build and protect their wealth through education. If you'd like us to answer one of your questions, then please email us. (Note: We will not respond to requests for stock picks.) There's a sharp divide between intelligence and wisdom. We're born with intelligence, yet accumulate wisdom along the way. That's surely a distinction any advanced investor will tell you. Even the savviest investors stumbled badly at the start, but they saw their performance improve as they learned from their mistakes. Here's what one reader asks about the subject:

Q. "I'm just starting to get into the market. What's the biggest mistake you see people like me make?"

- Will, Austin, Texas

A. Will, there are ample missteps that a novice investor can make, but the biggest challenge is haste. Investors are quick to act on a hot tip and they invest too much money right away. You're better off proceeding methodically with your investment research before you put a lot of eggs into any one basket.

Let me explain.

Investing isn't just about profits -- it can also be quite exciting. The challenge is to keep that excitement in check and remain circumspect while you are assessing a company's growth opportunities.

Years ago, a colleague of mine did just that. He was convinced that Apple (Nasdaq: AAPL) had a potentially lucrative opportunity with a newly launched music service called iTunes. Though we now know iTunes became a spectacular success, few on Wall Street initially grasped its importance. Indeed, shares of Apple languished under $15 in the first few quarters that iTunes was under way.

My colleague used that time to really dig in to the concept. He rightly wondered if iTunes would be a success if most other investors seemingly remained dubious. So he invested just $1,000 in Apple and proceeded to read up on the topic. He analyzed the pricing model, Apple's costs, barriers to entry, technology reviews and Apple's financial statements.

With each passing step, he grew more impressed, buying more shares along the way, until he had invested $5,000 in Apple. To be sure, he had to pay a little more for each successive block of shares as Apple had begun to rise in price. But $15 and $20 for a stock is small change when that stock eventually goes to $700 (where Apple eventually peaked).

It's especially important to proceed slowly when you are looking at an already popular stock that is being touted as a "can't-miss winner." In the middle of the past decade, the news media took note of a revolutionary way to extract natural gas from deep rock formations (known as shales). We now know this technique as fracking, and true to the hype, our nation's gas production is now soaring.

But in the early stages, investors quickly grew excited about the companies with the most real estate in these shale regions, and none had amassed as much land as Chesapeake Energy (NYSE: CHK). Investors rushed to buy this stock, even as it soared above $60 in 2006. (High natural gas prices at the time also made this company look like a potential profit gusher).

Chesapeake eventually received low marks for corporate governance by activist investors such as Carl Icahn. Along with others, Icahn reportedly pushed Chesapeake to add independent directors to the company's board and eliminate any separate profit-sharing agreements that CEO Aubrey McClendon allegedly had signed with the company. Still, shares have failed to rally above the $20 mark, even as the company reportedly has sought to address investors' concerns. Winning back credibility will take time.

Action to Take --> My colleague who invested in Apple understood the first rule of investing: If you come across a great investment idea, you have to do the legwork to verify that it is as promising as you suspect. You would be surprised at how many stocks look like bargains or have growth plans that seem exciting, only to find later that there were some obvious problems beneath the surface.

This article originally appeared on InvestingAnswers.com:
The Cardinal Sin Of Beginning Investing -- And How To Avoid It

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