Stocks have been on rampage since they hit their lows in 2009. Just in 2013 alone, the stock market gained 30%. And because of the recent gains, more individual investors have been getting into the market. And if you are one of the new investors, you will probably make a few mistakes before finally figuring out how stock investing works. Here are six of the biggest mistakes that new investors make in the stock market. I am guilty of all of these mistakes when I first started investing in stocks.
1) Fear Of Missing Out (FOMO)
When first starting out, it is extremely easy to be trigger-happy. You see a stock going up for consecutive days and want to get in before it goes up more. You do this because you fear that the price will never get back down and the stock will shoot straight up like a rocket. So you don’t want to miss out.
But the vast majority of the time, this simply isn’t the case. Stock goes up, then retraces back down, then goes up again, and then again goes down. That is how the stock market works; it is the natural nature of any market which operates upon supply and demand. Very rarely do you see a stock shoot straight up without going back to its support levels. So although you are tempted to buy a stock on its way up, you might want to wait it out to see to see how it moves and do a little more research before buying into a soaring stock.
2) Buying “Cheap” Stocks That Aren’t Really Cheap
A $1 stock can be extremely expensive and a $400 stock can be extremely cheap. The objective price per share is not an accurate measure of how cheap or expensive the stock is.
One of the first metric you should pay attention to is the price-to-earnings ratio (P/E ratio) if you want to evaluate the value of a stock. That is, how much people are willing to pay per dollar of the company’s earnings. Historically, the average P/E ratio has been hovering around 20 for the market as a whole. A company with a P/E ratio of 0-10 is considered undervalued. On the other hand, companies with higher P/E ratios (above 20) suggest that investors are expecting higher earnings in the future and therefore are investing in the future. However, it is more useful to measure P/E of one company against another company. A company not making money cannot have a P/E ratio.
With that said, the P/E ratio does not tell the whole story. A company without a P/E ratio (ie, not making money) can still be a good bet while a company with a low P/E ratio can still be a bad bet. The important thing is to look beyond just the share price of the stock and dive into the company’s operations and its financial metrics. If you want to get really good at diving into a company’s finances, you should definitely get a financial/corporate accounting book. I suggest getting The Basics of Understanding Financial Statements by Mariusz Skonieczny.
And watch out for penny stocks. Penny stocks do cost just pennies per share. However, they are extremely volatile, have very little information about them, and are extremely susceptible to market manipulation (ie pump-and-dump schemes). In addition, most brokers will charge a hefty fee for trading OTC stocks (another name for penny stocks). For instance, my brokerage OptionsHouse charges an additional fee of $0.005 per share of stock traded for stocks priced $2.00 or less. That may not seem like much, but if you are spending $300 to buy 15,000 shares of a $0.02 stock, that’s $75 in fees (plus $4.75 commission) just to buy $300 worth of shares. So if you you are new to stock investing, I strongly urge you to stay away from stocks worth less than $1—or even $3.
3) Do Not Know The Rules Of Investing
Rules set by the SEC is another thing many novice stock investors do not know. For instance, novice investors do not have a firm grasp of concepts of settlement period (T+3), free-riding violations, wash sales, and the numerous other SEC regulations. So before getting your feet wet in the market, get to know those specific stock investing rules first.
4) Buying Before Research
Not doing enough research before buying is a fatal flaw that many new investors suffer from. When I was a new investor, I relied on a lot of hearsay for my “investments” instead of doing my due diligence. I lost thousands that way.
Financial news and metrics can be extremely daunting to those new to the industry. Financial jargon is intimidating—-but knowing them can make or break you. Before buying, always do research on the individual company and its corresponding industry—whether it is its past failings, current earnings, or future prospects.
5) Owning Too Many Stocks
Many new investors will often hear the advice of diversifying being echoed. However, too much diversification can be a bad thing. What over-diversification does is that it dilutes your gains.
This is what happens to mutual funds—they invest in too many stocks and over-diversify—therefore their gains are diluted. However, mutual funds are designed (for the most part) to diversify in blue chip stocks to protect your money and grow it conservatively.
Unless you are near retirement, you should not be as conservative in your investments as most mutual funds. Over-diversification of your stock portfolio will lead to profit dilution. Even the famed investor Warren Buffett said “diversification is protection against ignorance. It makes little sense if you know what you are doing.”
At any one time, you should not have more than 10 stocks in your portfolio, but ideally you should have around 5.
6) Putting All Your Eggs In One Basket
On the flip side, putting all your eggs on one basket is also a mistake. Putting all your eggs in one basket is often more dangerous than over-diversifying. Sure the one sole company you own can run up and can give you 100% return on your investment—but that same stock can also plummet and cut your portfolio down to pennies.
If you are starting with $3,000 or less, invest in one company first. Then as you gradually put more money in your portfolio, you should buy other companies to hedge against potential losses.
If you are new to stock investing, take the time to learn the fundamentals as well as the technicals of stock investing. Read about the rules the SEC has in place and be sure to not make the six common mistakes summarized above. So if you are ready to get started investing in stocks, take a look at these ten cheap online brokerages to get started.