When learning any skill, it is best to start young. Investing is no different. Missteps are common when learning something new, but when dealing with money, there can be severe consequences. Investors who start young generally have the flexibility and time to take on risk and recover from their money-losing errors, and sidestepping the following common mistakes can help improve the odds of success.
5 Common Mistakes Young Investors Make
Procrastination can be detrimental when it comes to investing. Over the long-term, the stock market has risen, averaging about 10% per year. While there are years (and stretches of years) where the market does down, to take advantage of the tendency for stock prices to rise it is best to start investing as early and as often as possible. This could be as simple as buying an index fund or ETF each month with the savings set aside for investing.
Compounding is powerful, so the earlier that money starts working to make more money, the better off that investor will be down the road.
If a person starts investing at 25, they can be a millionaire at 60 with investing out half as much (each year) as someone who starts at 35.
2. Speculating Instead of Investing
A young investor is at an advantage. An investor's age affects how much risk they can take on. A young investor can seek out bigger returns by taking bigger risks. This is because if a young investor loses money, they have time to recover the losses through income generation. This may seem like an argument for a young investor to gamble on big payoffs, but it is not.
Instead of gambling or taking highly speculative trades, a young investor should look to invest in companies that have higher risk but greater upside potential over the long term. A big segment of the stock market, which has higher risk but also higher return potential are small-cap stocks. These are smaller, less established companies, but many of them go on to become household names with long-term rising stocks values. Others fade into obscurity. Young investors could invest in a diversified portfolio, or index fund, of small-cap stocks. But this wouldn't be recommended for older investors nearing retirement.
A final risk of gambling or highly speculative trades is that a large loss can scar a young investor and affect his or her future investment choices. This can lead to a tendency to shun investing altogether or to move to lower or risk-free assets at an age when it may not be appropriate.
3. Using Too Much Leverage
Leverage has its benefits and its pitfalls. If there is ever a time when investors can add leverage to their portfolios, it is when they are young. As mentioned earlier, young investors have a greater ability to recover from losses through future income generation. However, similar to highly speculative trades, leverage can shatter even a good portfolio.
If a young investor can stomach a 20% to 25% drop in his or her portfolio without getting discouraged, the 40% to 50% drop that would result at two times leverage may be too much to handle. The consequences are not only the loss, but the investor may become discouraged and overly risk-averse going forward.
One option is to use leverage in moderation, possibly with only a portion of the funds in the portfolio. For example, if a young investor accumulates a $100,000 portfolio, they could start using 2:1 margin/leverage on 10% of the portfolio, or another percentage they are comfortable with. This still increases risk, and potentially returns, on those specific trades, but the overall risk to the portfolio remains quite low.
4. Not Asking Enough Questions
If a stock drops a lot, a young investor might expect it to bounce right back. Maybe it will, and maybe it won't. Stock prices rise and fall all the time.
One of the most important factors in forming investment decisions is asking, "Why?" If an asset is trading at half of an investor's perceived value, there is a reason, and it is the investor's responsibility to find it. Young investors who have not experienced the pitfalls of investing can be particularly susceptible to making decisions without locating all the pertinent information.
What type of information an investor seeks out will depend on their goals. A young investor may decide they don't have enough time to learn how to invest for themselves, and so they get a financial advisor to help them out. The advisor will answer their questions and handle the investments.
Another type of young investor may not want to ask or research a lot of questions, and so they invest in index funds. They do it on their own but keep it simple.
The third type of young investor wants to know everything, and so they ask themselves questions and then set off to research the answer on their own.
All three are viable investing methods, but each requires a different approach such as high reliance on others with the advisor, to total self-reliance with the do-it-yourself investor.
5. Not Investing
As mentioned earlier, an investor has the best ability to seek a higher return and take on higher risk when they have a long-term time horizon. Young people also tend to be less experienced with having money. As a result, they are often tempted to focus on spending their money right now, without focusing on any long-term goals such as retirement. A lack of saving and investing while young may also lead to poor money habits as the person gets older.
While retirement may seem like a long way off, investing doesn't only need to be about retirement. Investing some money, instead of spending it, can increase wealth and quality of life in the short-term as well. If having more money is something a young person wants, investing is one way to get there.
The Bottom Line
Young investors should take advantage of their age and their increased ability to take on risk. Applying investing fundamentals early can help lead to a bigger portfolio later in life. Avoid gambling, and instead, focus on solid companies with long-term upside. This could be as simple as buying index funds. Leverage is a double-edged sword, so use it only in moderation, or not at all if uncomfortable with the additional risk.
Consider what type of investor you want to be, so you know what questions you should be asking of your advisor or yourself. Finally, start investing as soon as possible to start generating more wealth for now, and later in life.