You’re ready. You’ve saved money and it’s time for your first investment.
Stop right there.
Before taking the plunge, be sure to avoid these five undercurrents that can drown your plans for growing wealth. I fell victim to some of these. Learn from my mistakes, and you can become the Michael Phelps of investing.
1. Emotional buying and selling
When you’re starting out and looking for stock tips, you might hear advice like create an investment plan and stick to it. Easier said than done.
We all fall victim to emotion. When our hard-earned money is on the line, emotions can bomb our investment plans to pieces.
Take, for example, a scenario where the price of your stock is on a downward trend. Every day the price drops, anxiety rises. You become desperate and shed the stock just before it reverses to become a winner. I’ve seen this first-hand, like when my dad sold Apple (AAPL) at $45 per share. It’s currently close to $200.
Then, there’s the flipside. Your stock is doing great. It keeps rising. That’s greed steps in. Instead of selling at the target price, greed whispers, “Let’s wait to see if it goes higher.” Inevitably, the stock price drops, and suddenly, you’re looking at a loss.
It happened to me with Best Buy (BBY). I was to sell when it hit $75 per share, but then I got greedy. So I waited. In the blink of an eye, it went down to $49.
So how do you address the pull of emotions? A great tool is the limit order. You can set a predetermined price to buy or sell that aligns with your strategy. This takes the emotion out of it.
The other factor to keep in mind is that the stock market’s average return (when looking at the S&P 500) has been about 10% annually. Market fluctuations mean it’s not always that way (as you can see in this chart), but if you invest wisely and stick to a plan, you’ll come out ahead in the long run. Keeping this in mind can help calm those pesky emotions.
2. Research is not optional
So what do I mean by “invest wisely?” One word: research.
You’ve got to do some investigation to determine if you’re comfortable investing your money. Otherwise, you’re relying on luck.
It’s ideal to understand how the company is doing in terms of metrics affecting the stock price, such as revenue, costs, earnings per share and other performance indicators. But if you’re not a numbers person, you may be tempted to rely solely on stock tips.
While tips can be helpful, it must not be the main reason for investing. At minimum, you should know how the company you are eyeing makes its money.
I fell into this trap when I started out. I had a colleague who went to work for a company called Conductus. I had no idea what they did, but this colleague told me the company was on the brink of some amazing things. A hot insider tip, I thought. So I blindly bought the stock. After that, my colleague left that company, saying it wasn’t what he thought, while my investment tanked.
Learn from me: always do the research.
3. A lack of diversity can be deadly
When I was starting out, I didn’t have a lot of money to invest. So it seemed logical to put what little I had down on one company’s stock. But if you’re relying on one company and it does poorly, you could lose everything.
When I began investing, the bulk of my stock was from the company I worked for. That company eventually went bankrupt and the stock became worthless. Fortunately, I decided to diversify by buying shares of other companies. As a result, the bankruptcy didn’t affect me much.
That’s the strength of a diversified portfolio. By buying shares in different companies, you insulate yourself in case some stocks do poorly.
One popular way to build diversification is to invest in mutual funds. These are a basket of stocks. So although you might buy into a single mutual fund, you’re still getting shares from lots of different companies.
4. Skip the margin
When you’re starting out, if you were like me, there’s not a lot of money for investing. That’s when the siren call of buying on margin can draw you in.
It’s a popular way to increase your pool of funds because it’s essentially borrowing money to buy stock. It all sounds good, but like any loan, you have to pay it back with interest.
Also, the risk is high that you could lose everything, especially if the stock price drops. Consequently, it’s more likely emotions will infect your decision-making.
When you’re first starting out, just learning to do your research and building your investment strategy is already a lot to master. Playing with margin complicates matters just as you’re learning the ropes.
When I was starting out, a friend urged me to buy on margin. I decided the risks were too great, and that being a beginner, I needed to focus on developing an investment approach. By patiently building my portfolio, I found I never needed to buy on margin.
5. Uncle Sam is your friend
As they say, the only certainties in life are death and taxes. While taxes can be a heavy drain on income, one of the biggest boons of stock investments are the tax benefits. Understanding how taxes affect your returns is important to incorporate into your investment strategy when you’re starting out.
For instance, if you can hold onto a stock for at least a year, you pay long-term capital gains, a much smaller tax rate than if you were to buy and sell quickly. It’s a great way to keep more of what you earned.
Another benefit is when you realize one of your investments is not going to make it. You can write off the loss on your tax return.
That happened to me with Washington Mutual stock. Before the Great Recession, I saw Washington Mutual banks everywhere. When the Great Recession hit, the stock dropped incredibly low. I thought it was a bargain. But because I didn’t do my research, I failed to realize the company was in big trouble. It eventually went out of business. There was one silver lining, however — that tax write off.
The last word
The above five factors can dramatically affect the outcome of your investments. What makes them particularly deadly is that they can happen simultaneously. By not doing research, some of my early investments did poorly. Then emotions kicked in and compounded the problem.
Save yourself the heartache. Now that you have an idea of the common ways new traders can get in their own way, factor these into your investment strategy. By avoiding these mistakes, you can make the stock market work in your favor on the path to long-term financial success.
Robert “Izzy” Izquierdo was inculcated into the church of finance by his investor father (who achieved millionaire status through stocks). Izzy has bought and sold stocks for decades. As a technologist who has worked at Silicon Valley companies to tech startups, Izzy pursues his dual passions as digital domain expert by day and Wall Street wanderer by night.