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Heeding These 3 Warning Signs Will Make You a Better Investor

By Alex Carchidi - Feb 27, 2021 at 7:11AM

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Some quick reflection now can ward off big headaches down the line.

Whether it be falling for a pump-and-dump scheme, buying stock in a cartoonishly dysfunctional company, or panic-selling a soon-to-be-winner right before its takeoff, we've all been known to make investing mistakes. The good news is that it's possible to learn from these mistakes and do better, provided we understand what went wrong and what to look for next time around.

Each of the three warning signs I'll discuss today will be relevant for the rest of your investing career. If you heed them and act accordingly, I guarantee that you'll protect your portfolio from a few hefty shocks.

A set of six warning signs.

Image source: Getty Images.

1. You feel time pressure to buy or sell

Have you ever seen a stock's price jump, then rushed to your brokerage to buy it immediately, only to see its value collapse catastrophically soon after? If so, you're not alone. But next time you feel tempted to jump on a hot investment before the crowd shows up, you should recognize that you're at high risk of making a low-quality choice that could harm your portfolio's value.

Take Aurora Cannabis' (ACB -39.01%) price movements in the last 12 months as an example. If you had piled on when you heard that its stock was exploding in May of 2020 or February of 2021, you'd be sitting on some gnarly losses right now.

ACB Chart

ACB data by YCharts

When you're investing for the long term, short-term price movements that grab headlines are not something that you should place a lot of weight on when deciding whether to buy a stock. The fact that a stock's price is rising quickly today doesn't mean that it will continue to do so in the future. 

More importantly, the fear of missing out on a short-term price movement can drive you to invest in stocks that you haven't fully vetted.

2. You're not sure precisely what the company does (or how it's different from competitors)

If you're holding a stock, you need to know how the company makes its revenue today, and how it plans to make even more in the future. For smaller companies in one line of business, that's not such a daunting task. But when you start to invest in diversified businesses or conglomerates, it's easy to lose track of what's going on. That leaves you exposed to risks which you may not appreciate when you purchase the stock.

One good exercise to test your knowledge is to state what the company does in one or two simple sentences. 

Going back to our Aurora Cannabis example, that could be something like "it makes medicinal and recreational cannabis products and sells them in the U.S. and Canada." Then, add on another sentence explaining why the stock is worth your money more than its competitors. That could look like, "because it's making aggressive cost cuts that will take it closer to profitability," or even "because other stocks in the industry are overvalued in anticipation of cannabis legalization," assuming you believe those things are true.

3. You don't have a plan

When you're considering whether to purchase a stock, you need a rough plan. That plan should include the price at which you're comfortable with buying the stock, as well as your investing thesis for its increasing long-term value. If you're not sure how to judge the appropriate price level, start by examining the intrinsic value and go from there.

You should also plan for how long a newly purchased stock will live in your portfolio. Your plan could be as simple as "I'll hold this stock until I start to withdraw funds for retirement," or "I'll hold this stock for three years," or even "until it triples in value." Making a roadmap before you invest is helpful because it'll reduce the temptation to sell based on short-term setbacks. It'll also help you to stay focused on your portfolio goals over time.

In the context of Aurora Cannabis, the plan could be something like "I'd be willing to buy it at around $10.50 and hold it until 2025 (when marijuana legalization may be nationwide in the U.S.) or until it increases by 300%, whichever comes first." If the price subsequently dips below your target or above your goal, you've already taken a lot of the uncertainty out of your next decision.

Remember, you're not obligated to stick to your investing plan, especially if it's based on a set of assumptions that are starting to look incorrect. If a company's financial conditions change significantly, don't be afraid to chart a new course. Just make sure that you're keeping your eyes on the horizon rather than recent price history when you do.

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