Ready to start investing or to expand your trading beyond your 401(k)? Putting your money into the stock market is the best way to build wealth over the long term, but it does come with a fair amount of risk. The good news is, you can mitigate much of that risk by steering clear of a few common investing blunders. Here are four wealth-destroying moves you should avoid at all costs.
1. Investing cash you can't afford to lose
High on the list of novice investor mistakes is investing cash you can't afford to lose. Here's why that's problematic. Fear of loss creates desperation, and desperation pushes you to make poor trading decisions. Desperation might urge you to sell after a market crash to cap your losses, or to buy when share prices are rising to get in on the action. Follow both of those urges and you end up selling low and buying high -- and that's no way to make money. Too much desperation might even convince you to bet big on a risky position, in hopes of getting a quick payoff. And that's not really investing; it's gambling.
On the other hand, it's far easier to keep your cool and make logical decisions when you don't need those invested funds right away. The rule of thumb is not to invest any cash you plan on using within five years. That way, if share prices tank, you can set a go-forward plan without worrying about paying rent or putting food on the table. You'll also have the option to do nothing and ride out short-term volatility -- which is often the right approach. It certainly was the right move when the market crashed in March of 2020, given that those losses have largely reversed in three months.
2. Trying to turn a quick profit
Quick investing profits are somewhat overrated. Sure, you could lock in a gain by selling a position that's increased in value, but once you liquidate, you're sitting on cash that has to be reinvested somewhere. That kicks off a risky cycle of buying and selling. The longer you continue that trend, the more likely you are to make a wrong move and end up with a loss.
A better strategy is to buy quality positions and hold them for the long term. Look for large, mature companies that have proven their ability to weather all types of economic cycles. Reliable dividend payers are good choices, since they provide immediate income plus the opportunity for future growth. Or try large-cap, low-cost ETFs and S&P 500 index funds for immediate diversification. A good S&P 500 index fund will bring you near-market-level performance, which historically has been about 7% per year over the long-term.
3. Investing in securities or companies you don't understand
Legendary investor Warren Buffett has repeatedly warned novice investors to avoid investing in companies they don't understand. For most investors, that means focusing on consumer staples, real estate, utilities, and possibly financial services. Don't dabble in penny stocks with unclear business models or technology companies solving problems that don't affect your life. If you aren't in touch with what drives success for an organization, you can't evaluate its future potential or recognize when conditions change. That puts you at a disadvantage relative to investors who can make informed decisions.
The same advice holds true for the types of securities you choose. Mutual funds and stock shares can be fairly straightforward investments, but options, futures contracts, and even initial public offerings (IPOs) are not.
4. Buying on margin
Buying on margin is the practice of borrowing money from your brokerage to invest in stock. You'll pay interest on the loan, and your brokerage uses the positions in your account as collateral. If the value of that collateral declines substantially, you'll have to deposit more funds into the account to cover the shortfall. You repay the loan by liquidating your positions -- the brokerage pays back the loan first and distributes what's left to you.
The advantage of buying on margin is increased buying power. The disadvantage is the other side of that coin -- the more you can invest, the more you can lose. Buying on margin is also a clear violation of rule No. 1 above. If you're just starting your investing career, keep your potential losses limited to the cash you have on hand.
Slow and steady wins the race
Building wealth in the stock market isn't a sprint. It's an ultramarathon. You don't need an early win, a trendy tech stock, or a loan from your brokerage to cross the finish line. You need only the the discipline to invest consistently in quality positions over time. That's the simplest, most reliable approach.