The investing revolution has reached a new phase of growth. Millions of people are flooding into the stock market, many of them as beginning stock investors, and they're ready and eager to find ways to make money. Unfortunately, like anyone learning something for the first time, these investing rookies will inevitably make mistakes.
Fortunately, a lot of things beginners do wrong are easily avoidable. Unfortunately, it can cost you a ton of money if you have to learn them the hard way. Below are some of the most common things that new investors do wrong and what you should do instead.
1. Misunderstanding margin
Brokerage companies make it easy for new investors to open margin accounts. Many brokers will automatically give you a margin account unless you specifically request a cash account instead.
Margin accounts offer investors the option of investing more than the amount of cash they have on hand. By investing on margin, investors take advantage of loans that their broker is willing to give -- as long as the value of their account remains high enough to secure them against the risk of loss.
There are two problems with margin accounts. First, if you're not careful, you can sometimes end up trading on margin without even realizing it. If you focus on what brokers typically call "purchasing power" rather than on cash on hand, you could end up buying more shares than you have money to spend.
Even worse, once you invest on margin, you're vulnerable to margin calls. If the prices of your stocks fall, then your broker can demand repayment -- and even sell your stock positions on your behalf to repay the margin loan.
Misunderstandings about margin were linked to the suicide of one Robinhood investor last summer. Margin accounts are common, but misused, they can be more costly than you'd imagine. You can avoid this simply by opening a cash account rather than a margin account.
2. Using the wrong kind of orders
When you want to buy or sell stocks, you have to place an order with your broker. Brokers offer multiple types of orders, and each one works a little differently. Use the wrong one, and you could get a nasty surprise.
When you place a market order to buy a stock, you agree to pay whatever the market price is for your shares. With stocks that trade millions of shares each day, that's rarely a problem. But for thinly traded stocks and investors looking to take fairly large positions, a market order can actually send the stock price upward -- and you can end up paying more than you thought based on most recent share prices.
A limit order lets you determine the maximum price you're willing to pay for shares. However, there are risks with limit orders, as well. If the price never reaches your stated limit, then you'll never get the stock -- even if it only misses by a penny or two. If the share price climbs, you face the unpleasant choice of deciding whether to boost your limit or watch the stock run away from you.
Finally, stop loss orders are designed to sell your stock if the share price falls below a certain level. However, as with market buy orders, a stop loss order can lead to your receiving a lot less than you expected. You can use a stock loss limit order, but then, the sale may never go through if your limit order is above where the stock ends up trading.
Be sure to use the right order for the right situation, and you'll get a better result.
3. Forgetting about taxes
Finally, stock traders often neglect to consider the tax consequences of their stock sales. If you make a profit on a stock you've held for a year or less, then you'll pay your full ordinary income tax rate on your gains. You'll only get long-term capital gains treatment with correspondingly lower tax rates if you hold a stock longer than a year.
Long-term investing is generally a smarter strategy to follow, but if you're dead set on trading frequently, you should at least consider doing so with a retirement account like an IRA. Inside a tax-favored retirement account, you won't have to deal with tax issues on gains and losses, as there are only potential tax consequences when you withdraw money from the retirement account.
Be a smarter investor
Investing is a smart thing to do, and it's great to see so many people trying their hand at buying stocks for the first time. But if you want to make the most of your investing opportunities, be sure to avoid making these common mistakes. Your portfolio will perform all the better if you do.