Nobody's perfect. We are all going to have our wins and losses, especially when it comes to investing. But some of the mistakes you might make when trading stocks are actually pretty common, and by no means reserved exclusively for you alone. In fact, the majority of investors make many of the following mistakes.
The good news is that most of these mistakes can be avoided simply through awareness. We will take a look at the 10 most common mistakes and identify ways in which you may be able to stop the habits—or even turn them to your advantage.
- When investing, it's important to know some common pitfalls so you can be prepared to avoid them.
- The biggest investing mistake you can make is not investing at all, since you lose out on the power of compounding interest.
- It's also important to keep your investments diversified and avoid investing in stocks you don't understand.
- Other common mistakes include expecting too much, risking more than you can afford, and failing to do adequate research before investing.
Of all of the mistakes you might make on your investing journey, perhaps the greatest mistake you could make is not investing at all. Retirement is expensive, and unfortunately, most of us won’t be able to save enough without a lot of help from the stock market.
Imagine saving $250 per month from the age of 25 until you retire at age 65. If you were to keep that money in a bank account that does not accumulate interest, you would have just $120,000 by the time you retire. Unfortunately, that’s not likely to last you very long.
But what if you had invested that same $250? According to the Securities and Exchange Commission (SEC), the stock market has an average annual return of about 10%. With that, your $250 per month contribution would result in you having about $1.34 million by the time you retire. You saved the same amount of money throughout your working life, but putting that money into the stock market instead of a non-interest-bearing account made the difference of more than $1 million.
Buying Shares in a Business You Do Not Understand
Too often, investors gravitate towards the latest "hot" industry. They may know very little, or even nothing, about technology or biotech, or the specific business the underlying company is engaged within, yet they think it will be the next profitable investment.
But when you understand a business, you have a naturally built-in advantage over most other investors. For example, if you run a restaurant, you may be in tune with the back-end business involved with restaurant franchising. You will also see first-hand (and before they become public knowledge) the habits of the patrons. By extension, you will know if the industry is booming, getting slower, or cooling down, well before the vast majority of investors, making it easier to make strategic investment decisions.
When you invest outside your realm of understanding, you may not know the subtleties and the complexity of the business in question. This is not to say that you need to be a gold miner to invest in gold mining companies, or a medical doctor to invest in health care, but that certainly wouldn't hurt.
Putting All of Your Eggs in One Basket
Diversification is one of the foundations of responsible investing. Diversifying your portfolio helps to reduce your risk so that if one of your investments underperforms, it doesn’t necessarily impact your entire portfolio. When you put all of your eggs into one investment, on the other hand, one event could damage your entire portfolio, and therefore your financial future.
There are two ways to diversify your portfolio. First, you can diversify across asset classes. One example would be putting some of your money into stocks, some into bonds, and some into real estate. As a result, if the stock market crashes, but the bond market performs well, some of your investments still move in a positive direction.
The other way you can diversify is within asset classes. So, instead of putting all of your money into the stock of a single company or industry, you would buy stock in many different companies.
Investing in index funds, mutual funds, or ETFs is an easy way to diversify your portfolio through just one investment.
Expecting Too Much From the Stock
This is especially true when dealing with penny stocks. Most people treat low-priced stocks like lottery tickets and anticipate that they can turn their $500 or $2,000 into a small fortune. Of course, that can sometimes work, but it is not an appropriate mindset to have when you're getting into investing. You need to be realistic about what you are going to expect from the performance of the shares, even if such numbers are much more boring and mundane than the extreme levels for which you may hope.
Look at the performance of the stock you are interested in up until that point, and make a decision based on its historical trends and gains. While past performance is no guarantee of future results, it can be a good reference point to start with. You can use historical data to get an idea of the volatility and trading activity of the underlying shares.
Using Money You Cannot Afford to Risk
You would be stunned if you could see how different your trading style becomes when you are using money that you cannot afford to risk. Your emotions get heightened, your stress level goes through the roof, and you make buying and selling decisions you otherwise would have never made.
When evaluating stocks, consider your risk tolerance—your ability and willingness to lose a portion or all of your original investment in exchange for greater potential returns. You should never put yourself into a high-pressure situation where you are putting money on the line that you can’t risk to lose, such as money in your retirement fund or emergency savings.
When you invest with money that you can afford to risk, you will make much more relaxed trading decisions. Generally, you will have much more success with your trades, which will not be driven by negative emotions or fear.
Being Driven by Impatience
One of the most costly emotions you can have when your investing is impatience. Remember that stocks are shares in a particular business, and businesses operate much more slowly than most of us would typically like to see, or even than most of us would expect.
When management comes up with a new strategy, it may take many months, if not several years, for that new approach to start playing out. Too often, investors will buy shares of the stock, and then immediately expect the shares to act in their best interest.
This completely ignores the much more realistic timeline under which companies operate. In general, stocks will take much longer to make the moves that you are hoping for or anticipating. More importantly, the extreme highs and extreme lows don’t matter that much over a long-term investment horizon.
For example, the broader S&P 500 index has given an average annual return of 8.09% between 2000 and 2020. This includes five years when the index saw negative returns, including the great recession in 2008, when it was down by 36.5%.
When people first get involved with shares of the company, they must not let impatience get the best of them or their wallet.
What often makes investing profitable is the magic of compounding. Compounding takes time to really work, which is why those who start saving for retirement when they’re young often see the best returns.
Learning About Stocks From the Wrong Places
This is an extremely important point. There is no shortage of so-called experts who are willing to tell you their opinions, while packaging and presenting them as if they are educated and endlessly correct.
For every good piece of information which may be of benefit, you will probably see hundreds of pieces of really horrible guidance. Always remember that just because someone is being featured by top media does not mean they know what they are talking about. Even if they do have a stellar grasp of their topic, that still does not mean they will be right.
One of the most significant steps of investing well is to identify and isolate sources of guidance that consistently help you achieve profits. Generally, government-backed sources and nonprofit organizations are a good place to start for general investment advice or guidance. You could also consult a professional such as a financial advisor to guide you through the process.
Your job as an investor is to assess which sources of information should be trusted, and have demonstrated a reliable and ongoing trend of wisdom. Once you have identified those individuals or services that may lead to profits, you should still only partially rely on their thoughts, and combine those with your own due diligence and opinions to construct your trading decisions.
Not even the most experienced and successful investor can predict the future. If an investment professional guarantees a certain outcome on your investment, consider it a red flag.
Following the Crowd
In many cases, the majority of people only hear about an investment when it has already performed well. If certain types of stocks double or triple in price, the mainstream media tends to cover that move and tell everyone about how hot the shares have been.
Unfortunately, by the time the media tend to get involved with a story about shares rising, it is usually after the stock has reached its peak. The investment is overvalued by that point, and the media coverage comes late to the game. Nevertheless, the television, newspaper, internet, and radio coverage push the stocks even higher into excessively overvalued territory.
One example of this trend is the recent hype around the GameStop stock. By the time the surge reached the mainstream media, most of the gains had already been made. Those investors who got in too late likely ended up losing money.
Averaging down is typically used by investors who have made a mistake already, and they need to cover their error. For example, if they bought the stock at $3.50, and it drops to $1.75, they can make that mistake look a little bit less awful by purchasing a whole bunch more shares at this new, lower price.
The result is that now they've bought the stock at $3.50, and more at $1.75, so their average price per share is much lower. This makes their loss on the stock appear far smaller than it truly is.
However, what is really happening is that the individual bought a stock that dropped in value, and now they are sinking even more money into this losing trade. This is why some analysts suggest that averaging down is just throwing good money after bad.
Averaging down is typically used as a crutch to help investors cover the mistake they have already made. A more effective strategy is to average up, where you purchase more of a stock once it starts to move in the direction you are anticipating. The share price activity is confirming that you made a good call.
Doing Too Little Due Diligence
Venture capitalists and investment funds perform due diligence regularly to ensure their investments are worthwhile. With a proper due diligence strategy that is predetermined, organizations are more likely to not be blindsided and make well-evaluated investment decisions, according to the Global Impact Investing Network.
An individual investor should also perform proper due diligence, especially with highly speculative and volatile penny stock shares. The more due diligence you perform, the better your investing results will become. If you look at every warning sign, the potential risks, and every aspect of a company, you're much less likely to be surprised by any individual event that afflicts the business.
The vast majority of investors do not even come close to doing enough due diligence into the companies that they invest in. Most people just want to find a company that seems to make sense and should increase in value because the underlying industry (at least in their mind) is presumably up-and-coming.
For example, electric cars are becoming more popular, so people might assume that investing in an electric car stock is a good idea. Unfortunately, being a good investor takes a lot more than the simplified, surface considerations.
The Bottom Line
Ideally, you will not be committing too many of these common errors. However, the fact of the matter is that the majority of investors will make some of the mistakes which we've discussed in the article above.
Luckily, you can channel your inner teenager and learn from your mistakes. In fact, most people learn more from their losses than they do from their gains.
Given enough time, and a sufficient number of trades, you will be in a better and (hopefully) more profitable situation. Ideally, you will phase out the common mistakes quickly enough that you still have a big part of your portfolio left on the other side. Then, with your newfound wisdom, you should be able to start gathering some profits.