There is a distinct difference between speculating and investing. Speculating is short-term-minded trading with the intention of forecasting the movement of a stock or any other security and profiting from volatility if the prediction turns out to be correct. Investing, on the other hand, is something profoundly different.
When investing you first have to do some serious work researching and valuing companies. This also requires you to read the company's financial reports in order to get a solid understanding of the business model as well as the company's financial history.
Investing also requires investors to think long-term which can make all the difference in the stock market.
But trading, in the pure sense of the word, seems to rule the overall activity in the capital markets. Professionals, for instance, employ complex trading algorithms, enlist the help of computers and engage in high-frequency trading in order to be just a fraction of a second faster when it comes to order execution.
Despite the allure of the stock trader, speculating rather than investing in companies can be a dangerous undertaking and novice investors in particular tend to make three crucial mistakes when embarking on their first stock market adventures.
1. Transaction costs
Ask any investor or trader and he will tell you how quickly your returns can be smashed by constant transaction activity. Buying and selling stocks or other securities isn't for free: Any time you make a trade, your broker smiles and collects a provision, whether your transaction is profitable or not.
Transaction costs pile up incredibly quickly and put downward pressure on your performance. Trading in and out of stocks is a sure way of losing a lot of money.
Understand that virtually everybody in the marketplace is under pressure to be active and fells compelled to trade -- and this isn't a good thing for reflective decision making.
2. Don't chase the market
This is pretty much "Behavioral Finance 101." If you chase the market you will quickly find yourself willing to pay almost any price just so you can jump on the bandwagon.
Fear of missing out is an emotional trap that can cost you dearly and it often leads to stock market bubbles where investors don't care about the price they pay.
Chasing the market, or any security for that matter, is a great way of losing your shirt. Also: Do not believe in "hot stock tips" being passed around. In the stock market, there are no sure things. Ever.
3. Losing sight of the big picture
Probably the biggest problem with short-term trading is that many traders lose sight of the big picture.
If you just concentrate, for instance, on a quarterly earnings release in order to make up your mind about a company, you are at risk of missing more fundamental, intangible developments such as a solidifying turnaround in a company's business or a promising reorganization.
Those developments need time to play out and traders might leave significant returns on the table by focusing on short-term financial performance or intraday swings in the stock price.
The Foolish bottom line
Thinking about the long term and doing real valuation work has many advantages over constant trading where people are made believe the grass is always greener on the other side.
Trading can be extremely costly and it requires you to be a great market timer who knows exactly when stocks will rise or fall.
Instead of trading, consider the opposite: Invest for the long term based on sound fundamentals, such as consistently rising revenues and earnings. Warren Buffett, arguably the most successful investor in modern times, certainly prefers this approach to making money and maybe you should, too.
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