There are some common mistakes that first-time investors have to be aware of before they try their hand at picking stocks like renowned investors like Warren Buffett or shorting like George Soros.
6 Dangerous Moves For First-Time Investors
- Investing can be an exciting way to grow your wealth and secure your financial future.
- First-time investors, however, tend to repeat similar mistakes that can undermine their success.
- Investing emotionally, chasing fads, loading up on penny stocks, and failing to diversify are all examples of potential missteps.
- When you are starting to invest, it is best to start small and take the risks with money you are prepared to lose
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 know before jumping in.
The basic metrics such as book value, dividend yield, price-earnings ratio (P/E) are fundamental items to learn. Understanding how they are calculated, where their major weaknesses lie, and where these metrics have generally been for a stock and its industry over time can help a new investor immensely.
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.
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. Losing even $0.50 on a penny stock could mean a 100% loss.
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).
Going All in With One Investment
Investing 100% of your capital in a specific investment is usually not a good move (even 100% in specific commodity futures, forex, or bonds). Even the best companies can have issues and see their stocks decline dramatically.
Investors have a lot more upside by deciding to throw diversification to the wind, but this also carries 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. Exchange traded funds (ETFs) are a great way to get broad exposure.
Leveraging your money by using a margin means that you borrow money to buy more stock than you can afford. Using leverage magnifies both the gains and the losses on a given investment.
As an example, assume you have $100 and borrow $50 to buy $150 of 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 a 75% return. But if the stock declines 50%, you lose all the money you borrowed, plus some.
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. However, 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).
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 both emergencies and opportunities.
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 behavioral biases.
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. Investors are competing with professional firms that not only get information the second it becomes available but also know how to properly analyze and act on that knowledge.
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.