8 Mistakes New Stock Investors Make
Knowing these common pitfalls will help you avoid them
For people wishing to enter the stock market for the first time, getting started can be the biggest hurdle to clear. Should one buy shares in mutual funds, exchange traded funds (ETFs), or individual shares of companies? Is there a right time to buy? How does one select a brokerage?
These and other questions can cause paralysis by analysis. As the familiar mantra says, it’s not about timing the market, but rather time in the market. That means it’s important to set clear investment objectives, open a brokerage account with a trusted firm, and start investing with a long-term view. You’ll gain knowledge over time, and your investment strategy may change, but getting started sooner rather than later and not overcomplicating matters is a good first step.
It’s important to avoid the errors that many beginning stock market investors make. In this article, we will review some of the most common investment mistakes and how to avoid them.
1. Investing Money That Should Be Used Differently
If you have credit card debt or high-interest loans, it is often wiser to pay off that debt before investing in stocks. The average annual return of the S&P 500 since 2000 is slightly more than 8%. In five of those years, the S&P 500 lost investors money. Many credit cards charge annual interest rates of 18% or higher. You improve your overall financial situation if you eliminate high-interest debt first and build an emergency savings fund that can cover your living expenses for a minimum of six months before starting to invest money in the stock market.
2. Not Establishing Clear Investment Goals
Having a clear vision of why you are investing—whether for a down payment on a home, children’s college education, retirement, or something else—is necessary to create the proper investment strategy, assemble the right portfolio, and set appropriate objectives. Establishing an investment goal lets you set a time horizon for your investment strategy. A 35-year-old who is investing for retirement may create a different investment portfolio than someone the same age who is investing for a pre-teen child’s college education.
Stocks are generally considered long-term investments that should be held over a period of several years.
3. Buying Financial Products You Don’t Fully Understand
Peter Lynch, a former Fidelity mutual fund manager who racked up oversized returns for investors between 1977 and 1990, was a huge proponent of investing in companies whose products or services you understand. You may wish to start your stock analysis within an industry you work in or know a lot about.
Lynch’s advice can also be interpreted as advising an investor to complete a thorough assessment of a company, its competitors, and the business lines it operates in before buying shares. Too many investors chase after hot companies or sectors without understanding them. If you have confidence that a sector has long-term growth potential (such as biotech), but you don’t feel comfortable investing in a single company within that sector, it may make sense to find a reputable mutual fund or ETF that focuses on that industry to hedge your risk.
4. Trading Too Often
In today’s world of commission-free stock trading, it can be tempting to trade in and out of stocks frequently. However, there is ample research that shows frequently buying and selling stocks in an attempt to buy low and sell high often leads to lower returns than buying and holding. Recent research by the University of British Columbia's Sauder School of Business shows that not only do investors who try to time the market usually get lower returns, they introduce more volatility into their portfolio. In other words, they assume more risk.
Day trading, which is defined by the Financial Industry Regulatory Authority (FINRA) as buying, then selling, or selling short (speculating on the stock’s decline in price), then re-buying the same security on the same day, has become increasingly popular. Many day traders buy stocks on margin (with borrowed money) or leverage capital (borrow to buy additional assets) in order to purchase securities, which can lead to significant losses.
5. Buying Stock Without Reading the 10-K
Most U.S. companies are required to file a 10-K each year with the U.S. Securities and Exchange Commission (SEC). These forms provide a detailed review of a company, the risks it faces, and the operating and financial results for the fiscal year. Company executives also may discuss their perspective on business results and the company’s strategy moving forward.
A shorter version of a 10-K, known as a 10-Q, is filed quarterly. Both 10-K and 10-Q reports contain a wealth of information that investors should review before purchasing shares in a company. The documents are free and can be downloaded online from a company's website and public databases such as the SEC's EDGAR.
6. Buying Stock on Margin
A cash account with a brokerage limits an investor to purchase only as many equities as he or she can purchase from what’s in the account. A margin account allows an investor to borrow money from the brokerage to purchase securities. Margin accounts increase investors’ purchasing power, but also expose them to increased risk. In other words, you can lose more money than you have invested. A brokerage can force an individual to sell shares of stock that were purchased on margin when their price falls, or can sell shares without consulting with the account owner to pay for a shortfall in the margin account.
Margin accounts are extremely risky and are generally not appropriate for beginning investors.
7. Letting Emotions Drive Investment Decisions
Any activity that involves significant amounts of money has the potential to be emotional. Short-term success in the stock market can generate exuberance—and short-term losses can cause despair. Both emotions can lead to investment mistakes. As we have discussed, investors should use a variety of tools to help them research stocks they are considering purchasing or that they already own. These include 10-K and 10-Q reports, analyst insights, news stories and professional investment consultants or possibly a financial planner.
The SEC reports that investors are increasingly turning to social media and social networking platforms to crowdsource investment data and ideas. The agency warns that information posted on these platforms may be inaccurate, incomplete, or misleading. Social media posts may have a hidden agenda that does not serve investors’ best interests. The way this information is presented can lead to buy or sell decisions fueled by emotions and impulses, which is a risky way to approach investing.
8. Failing to Diversify
If diversification isn’t the No. 1 rule of investing, it’s in the top three. Building an investment portfolio that contains a broad range of stocks or stock-owning mutual funds from a variety of sectors—in addition to holding bonds, cash, and other asset classes that help balance stocks’ risk—is the best way to achieve appropriate levels of risk and return in various market scenarios. Diversification of equities means not only holding stocks of large and small U.S. companies from different industries, but also owning shares of companies based in other countries or mutual fund shares that invest abroad.
The Bottom Line
Beginning to invest can be intimidating, but if you are aware of common pitfalls and take the necessary precautions to avoid them, starting slow and learning as you go can lead to long-term investment success.
Many stock market investors feel comfortable starting with index mutual funds that track the returns of a particular market index and learning more about how to research companies before buying individual shares of stock. Of course, it is wise to consult with a professional financial advisor who can help you match your investment objectives with your approach.
The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.