For people who wish to enter the stock market for the first time, getting started can be the biggest hurdle to clear. Should you buy shares in mutual funds, exchange-traded funds (ETFs), or individual shares of companies? Is there a right time to buy? How do you select a brokerage?
These and other questions can cause paralysis. As the familiar mantra says: It’s not about timing the market; rather, it's about 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. While your investment strategy may change, getting started sooner rather than later is a good first step.
Be sure to avoid the errors that many beginners make. Learn about some of the most common mistakes and how to avoid them.
- Knowing the common mistakes that new stock investors make can help you avoid them.
- Some mistakes include: investing money that should be used differently, not establishing clear goals, buying securities you don't understand, and trading too often.
- Other mistakes include: buying stocks without reading the 10-K, buying stock on margin, letting emotions drive you, and failing to diversify.
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 from 2000 to 2020 was 8.09%.
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 financial situation if you pay down high-interest debt while building an emergency fund. Then, build an emergency savings fund that can cover your living expenses for a minimum of six months. Next, you can think about starting to invest money in the stock market.
2. Not Establishing Clear Investment Goals
Be sure to have a clear vision of why you are investing. Maybe it's a down payment on a home. Maybe it's your children’s education. Or, you might be investing for retirement or something else. No matter the reason, having a goal is a helpful step in choosing the right investment strategy.
Establishing an investment goal lets you set a time horizon. A 35-year-old who is investing for retirement will almost certainly create a different investment portfolio from someone the same age who is investing for their child's future education.
Stocks are generally considered long-term investments. That means they should be held over a period of several years.
3. Buying Financial Products You Don’t Fully Understand
Peter Lynch is a former Fidelity mutual fund manager. He racked up oversized returns for investors between 1977 and 1990. Lynch 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 that 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. This is crucial to do 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. This can help 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 often. But there is plenty of research showing that frequently buying and selling stocks often leads to lower returns than buying and holding. According to the University of British Columbia's Sauder School of Business: not only do those who try to time the market more often get lower returns, but they also introduce more volatility into their portfolio. In other words, they assume more risk.
Day trading 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, This can lead to big 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 results for the fiscal year. 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. Investors should review this before buying shares. The documents are free; they can be downloaded online from a company's website. You also can find them in 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 they 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 they also expose them to increased risk. In other words, you can lose more money than you have invested.
A brokerage can force you to sell shares of stock that were purchased on margin when their price falls. Or, it can sell shares without consulting with the account owner to pay for a shortfall in the margin account.
Margin accounts are extremely risky. They generally not appropriate for beginners.
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. You should use a variety of tools to research stocks you are considering buying...or those you already own. These include 10-K and 10-Q reports, analyst insights, news stories, and professional investment consultants.
The SEC reports that investors are 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. It doesn't always serve your best interests. The way the information is presented can lead to buy or sell decisions fueled by emotions and impulses. This 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 is the best way to achieve appropriate levels of risk and return in various market scenarios. This should be in addition to holding bonds, cash, and other asset classes that help balance stocks’ risk.
Diversification of equities doesn't only mean holding stocks of large and small U.S. companies from different industries. You should also own shares of companies based in other countries or mutual fund shares that invest abroad.
The Bottom Line
Beginning to invest can be intimidating. But being aware of common pitfalls, taking the necessary precautions to avoid them, starting slowly, 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.