Making mistakes is part of the learning process when it comes to trading. Traders generally buy and sell securities more frequently and hold positions for much shorter periods than do traditional investors. Such frequent trading and shorter holding periods can result in mistakes that could wipe out a new trader's investing capital quickly.
While traders of all stripes are guilty of the following mistakes from time to time, beginner traders should be especially wary of making them, as their capacity and capability to bounce back from a severe trading setback likely would be much less than for experienced traders.
1. No Trading Plan
Experienced traders get into a trade with a well-defined plan. They know their exact entry and exit points, the amount of capital to invest in the trade and the maximum loss they are willing to take. Beginner traders may not have a trading plan in place before they commence trading; and even if they have a plan, they may be more prone to abandon it than would seasoned traders if things are not going their way. Or they may reverse course altogether—for example, going short after initially buying a security because its price is declining—only to end up getting whipsawed.
Chasing Performance vs. Rebalancing
Many investors select asset classes, strategies, managers, and funds based on a recent strong performance. The feeling that "I'm missing out on great returns" has probably led to more bad investment decisions than any other single factor. If a particular asset class, strategy, or fund has done extremely well for three or four years, we know one thing with certainty: We should have invested three or four years ago. Now, however, the particular cycle that led to this great performance may be nearing its end. The smart money is moving out, and the dumb money is pouring in. Stick with your investment plan and rebalance, which is the polar opposite of chasing performance.
What is rebalancing?
Rebalancing is the process of returning your portfolio to its target asset allocation as outlined in your investment plan. Rebalancing is difficult because it forces you to sell the asset class that is performing well and buy more of your worst-performing asset classes. This contrarian action is very difficult for many investors. In addition, rebalancing is unprofitable right up to that point where it pays off spectacularly (think U.S. equities in the late 1990s), and the underperforming assets start to take off.
However, a portfolio allowed to drift with market returns guarantees that asset classes will be overweighted at market peaks and underweighted at market lows – a formula for poor performance. The solution? Rebalance religiously and reap the long-term rewards.
Not considering your own risk aversion
Do not lose sight of your risk tolerance, or your capacity to take on risk. If you are the sort of investor who can’t stomach volatility and the multiple ups and downs associated with the stock market, maybe you would be better off investing in the blue-chip stock of an established firm rather than in the volatile stock of a startup firm.
Remember that the return you expect comes with a risk. If an investment offers very attractive returns, also look at its risk profile and see how much money you could lose if things go wrong. And do not invest more than you can afford to lose.
A too-short a time horizon, or not having one
Also, don’t invest without a time horizon in mind. If you are planning to accumulate money to buy a house, that could be more of a medium-term time frame. However, if you are investing to finance a young child’s college education, that is more of a long-term investment. You will have to find investments suitable to your time horizon.
If you are saving for retirement 30 years hence, what the stock market does this year or next shouldn't be the biggest concern. Even if you are just entering retirement at age 70, your life expectancy is likely 15 to 20 years. If you expect to leave some assets to your heirs, then your time horizon is even longer. Of course, if you are saving for your daughter's college education and she's a junior in high school, then your time horizon is appropriately short and your asset allocation should reflect that fact. In general, though, most investors are too focused on the short term.
2. Not Using Stop-Loss Orders
A big sign that you don't have a trading plan is not using stop-loss orders. Tight stop losses generally mean that losses are capped before they become sizable. While there is a risk that a stop order on long positions may be implemented at levels well below those specified if the security gaps lower, the benefits of such orders outweigh this risk. A corollary to this common trading mistake is when a trader cancels a stop order on a losing trade just before it can be triggered because he or she believes that the security would reverse course imminently and enable the trade to still be successful.
3. Letting Losses Mount
One of the defining characteristics of successful traders is their ability to take a small loss quickly if a trade is not working out and move on to the next trade idea. Unsuccessful traders, on the other hand, can become paralyzed if a trade goes against them. Rather than taking quick action to cap a loss, they may hold on to a losing position in the hope that the trade will eventually work out. A losing trade can tie up trading capital for a long time and may result in mounting losses and severe depletion of capital.
4. Averaging Down (or Up)
Averaging down on a long position in a blue-chip stock may work for an investor who has a long investment horizon, but it may be fraught with peril for a trader who is trading volatile and riskier securities. Some of the biggest trading losses in history have occurred because a trader kept adding to a losing position, and was eventually forced to cut the entire position when the magnitude of the loss became untenable. Traders also go short more often than conservative investors and tend toward averaging up, because the security is advancing rather than declining. This is an equally risky move that is another common mistake made by a novice trader.
The importance of accepting losses
Far too often investors fail to accept the simple fact that they are human and prone to making mistakes just as the greatest investors do. Whether you made a stock purchase in haste or one of your long-time big earners has suddenly taken a turn for the worse, the best thing you can do is accept it. The worst thing you can do is let your pride take priority over your pocketbook and hold on to a losing investment. Or worse yet, buy more shares of the stock. as it is much cheaper now.
This is a very common mistake, and those who commit it do so by comparing the current share price with the 52-week high of the stock. Many people using this gauge assume that a fallen share price represents a good buy. But the fact that a company's share price happened to be 30 percent higher last year will not help it earn more money this year. That's why it pays to analyze why a stock has fallen.
Understand the fundamentals and false buy signals
Deteriorating fundamentals, the resignation of a chief executive officer (CEO), or increased competition are all possible reasons for a lower stock price; but these same reasons also provide good clues to suspect that the stock might not increase anytime soon. A company may be worth less now for fundamental reasons. It is important to always have a critical eye, as a low share price might be a false buy signal.
Avoid buying stocks that simply look like a bargain. In many instances, there is a strong fundamental reason for a price decline. Do your homework and analyze a stock's outlook before you invest in it. You want to invest in companies which will experience sustained growth in the future.
A company's future operating performance has nothing to do with the price at which you happened to buy its shares. When there is a sharp decrease in your stock's price, try to determine the reasons for the change and assess whether the company is a good investment for the future. If it's not, move your money into a company with better prospects.
5. Too Much Margin
Margin—using borrowed money to purchase securities—can help you make more money, but it can also exaggerate your losses, which makes it a potential detriment. The worst thing you can do as a new investor is become carried away with what seems like free money. If you use margin and your investment doesn't go the way you planned, then you end up with a large debt obligation for nothing. Ask yourself if you would buy stocks with your credit card. Of course, you wouldn't. Using margin excessively is essentially the same thing, albeit likely at a lower interest rate.
Further, using margin requires you to monitor your positions much more closely because of the exaggerated gains and losses that accompany small movements in price. If you don't have the time or knowledge to keep a close eye on and make decisions about your positions, and their values drop then your brokerage firm will sell your stock to recover any losses you have accrued.
As a new investor, use margin sparingly, if at all; and only if you understand all of its aspects and dangers. It can force you to sell all your positions at the bottom, the point at which you should be in the market for the big turnaround.
Learning about leverage
According to a well-known investment cliché, leverage is a double-edged sword because it can boost returns for profitable trades and exacerbate losses on losing trades. Beginner traders may get dazzled by the degree of leverage they possess—especially in forex (FX) trading—but may soon discover that excessive leverage can destroy trading capital in a flash. If a leverage ratio of 50:1 is employed—which is not uncommon in retail forex trading—all it takes is a 2% adverse move to wipe out one's capital. Forex brokers like IG Group must disclose to traders that more than three-quarters of traders lose money because of the complexity of the market and the downside of leverage.
6. Following the Herd
Another common mistake made by new traders is that they blindly follow the herd; as such, they may either end up paying too much for hot stocks or may initiate short positions in securities that have already plunged and may be on the verge of turning around. While experienced traders follow the dictum of the trend is your friend, they are accustomed to exiting trades when they get too crowded. New traders, however, may stay in a trade long after the smart money has moved out of it. Novice traders may also lack the confidence to take a contrarian approach when required.
All your eggs not in one basket
Diversification is a way to avoid overexposure to any one investment. Having a portfolio made up of multiple investments protects you if one of them loses money. It also helps protect against volatility and extreme price movements in any one investment.
Many studies have proved that most managers and mutual funds underperform their benchmarks. Over the long term, low-cost index funds are typically upper second-quartile performers or better than 65%-to-75% of actively managed funds. Despite all of the evidence in favor of indexing, the desire to invest with active managers remains strong. John Bogle, the founder of Vanguard, says it's because: "Hope springs eternal. Indexing is sort of dull. It flies in the face of the American way [that] "I can do better.'"
Index all or a large portion (70%-to-80%) of your traditional asset classes. If you can't resist the excitement of pursuing the next great performer, then set aside about 20%-to-30% of each asset class to allocate to active managers. This may satisfy your desire to pursue outperformance without devastating your portfolio.
7. Shirking Homework
New traders are often guilty of not doing their homework or not conducting adequate research, or due diligence, before initiating a trade. Doing homework is critical because beginning traders do not have the knowledge of seasonal trends, or the timing of data releases, and trading patterns that experienced traders possess. For a new trader, the urgency to make a trade often overwhelms the need for undertaking some research, but this may ultimately result in an expensive lesson.
It is a mistake not to research an investment that interests you. Research helps you understand a financial instrument and know what you are getting into. If you are investing in a stock, for instance, research the company and its business plans. Do not act on the premise that markets are efficient and you can’t make money by identifying good investments. While this is not an easy task, and every other investor has access to the same information as you do, it is possible to identify good investments by doing the research.
Do not buy on unfounded tips
Everyone probably makes this mistake at one point or another in their investing career. You may hear your relatives or friends talking about a stock that they heard will get bought out, have killer earnings or soon release a groundbreaking new product. Even if these things are true, they do not necessarily mean that the stock is "the next big thing" and that you should rush onto your online brokerage account to place a buy order.
Other unfounded tips come from investment professionals on television and social media who often tout a specific stock as though it's a must-buy, but really is nothing more than the flavor of the day. These stock tips often don't pan out and go straight down after you buy them. Remember, buying on media tips is often founded on nothing more than a speculative gamble.
This isn't to say that you should balk at every stock tip. If one really grabs your attention, the first thing to do is consider the source. The next thing is to do your own homework so that you know what you are buying and why. For example, buying a tech stock with some proprietary technology should be based on whether it's the right investment for you, not solely on what a mutual fund manager said in a media interview.
Next time you're tempted to buy based on a hot tip, don't do so until you've got all the facts and are comfortable with the company. Ideally, obtain a second opinion from other investors or unbiased financial advisors.
Too much attention given to financial media
There is almost nothing on financial news shows that can help you achieve your goals. There are few newsletters that can provide you with anything of value. Even if there were, how do you identify them in advance?
If anyone really had profitable stock tips, trading advice, or a secret formula to make big bucks, would they blab it on TV or sell it to you for $49 per month? No. They'd keep their mouth shut, make their millions and not need to sell a newsletter to make a living. Solution? Spend less time watching financial shows on TV and reading newsletters. Spend more time creating—and sticking to—your investment plan.
Overlooking the big picture when buying a stock
For a long-term investor, one of the most important but often overlooked things to do is qualitative analysis, or to look at the big picture. Legendary investor and author Peter Lynch once stated that he found the best investments by looking at his children's toys and the trends they would take on. The brand name is also very valuable. Think about how almost everyone in the world knows Coke; the financial value of the name alone is therefore measured in the billions of dollars. Whether it's about iPhones or Big Macs, no one can argue against real life.
So pouring over financial statements or attempting to identify buy and sell opportunities with complex technical analysis may work a great deal of the time, but if the world is changing against your company, sooner or later you will lose. After all, a typewriter company in the late 1980s could have outperformed any company in its industry, but once personal computers started to become commonplace, an investor in typewriters of that era would have done well to assess the bigger picture and pivot away.
Assessing a company from a qualitative standpoint is as important as looking at its sales and earnings. Qualitative analysis is a strategy that is one of the easiest and most effective for evaluating a potential investment.
8. Trading Multiple Markets
Beginning traders may tend to flit from market to market—that is, from stocks to options to currencies to commodity futures, and so on. Trading multiple markets can be a huge distraction and may prevent the novice trader from gaining the experience necessary to excel in one market.
9. Don't Forget Tax and Fees
Keep in mind the tax consequences before you invest. You will get a tax break on some investments such as municipal bonds. Before you invest, look at what your return will be after adjusting for tax, taking into account the investment, your tax bracket, and your investment time horizon.
Do not pay more than you need to on trading and brokerage fees. By holding on to your investment and not trading frequently, you will save money on broker fees. Also, shop around and find a broker that doesn't charge excessive fees so you can keep more of the return you generate from your investment. Investopedia has put together a list of the best discount brokers to make your choice of a broker easier.
10. The Danger of Hubris
Trading is a very demanding occupation, but the "beginner's luck" experienced by some novice traders may lead them to believe that trading is the proverbial road to quick riches. Such overconfidence is dangerous as it breeds complacency and encourages excessive risk-taking that may culminate in a trading disaster.
From numerous studies, including Burton Malkiel's 1995 study entitled: "Returns From Investing In Equity Mutual Funds," we know that most managers will underperform their benchmarks. We also know that there's no consistent way to select, in advance, those managers that will outperform. We also know that very few individuals can profitably time the market over the long term. So why are so many investors confident of their abilities to time the market and/or select outperforming managers? Fidelity guru Peter Lynch once observed: "There are no market timers in the Forbes 400."
Inexperienced day trading
If you insist on becoming an active trader, think twice before day trading. Day trading can be a dangerous game and should be attempted only by the most seasoned investors. In addition to investment savvy, a successful day trader may gain an advantage with access to special equipment that is less readily available to the average trader. Did you know that the average day-trading workstation (with software) can cost in the tens of thousands of dollars? You'll also need a sizable amount of trading money to maintain an efficient day-trading strategy.
The need for speed is the main reason you can't effectively start day trading with the extra $5,000 in your bank account. Online brokers' systems are not quite fast enough to service the true day trader; literally, pennies per share can make the difference between a profitable and losing trade. Most brokerages recommend that investors take day-trading courses before getting started.
Unless you have the expertise, a platform, and access to speedy order execution, think twice before day trading. If you aren't very good at dealing with risk and stress, there are much better options for an investor who's looking to build wealth.
Underestimating your abilities
Some investors tend to believe that they can never excel at investing because stock market success is reserved for sophisticated investors only. This perception has no truth at all. While any commission-based mutual fund salesmen will probably tell you otherwise, most professional money managers don't make the grade either, and the vast majority underperform the broad market. With a little time devoted to learning and research, investors can become well-equipped to control their own portfolios and investing decisions, all while being profitable. Remember, much of investing is sticking to common sense and rationality.
Besides having the potential to become sufficiently skillful, individual investors do not face the liquidity challenges and overhead costs of large institutional investors. Any small investor with a sound investment strategy has just as good a chance of beating the market, if not better than the so-called investment gurus. Don't assume that you are unable to successfully participate in the financial markets simply because you have a day job.
The Bottom Line
If you have the money to invest and are able to avoid these beginner mistakes, you could make your investments pay off; and getting a good return on your investments could take you closer to your financial goals.
With the stock market's penchant for producing large gains (and losses), there is no shortage of faulty advice and irrational decision making. As an individual investor, the best thing you can do to pad your portfolio for the long term is to implement a rational investment strategy that you are comfortable with and willing to stick to.
If you are looking to make a big win by betting your money on your gut feelings, try a casino. Take pride in your investment decisions, and in the long run, your portfolio will grow to reflect the soundness of your actions.