When the stock markets are soaring and you see securities prices increasing each time you look at them, you may get major FOMO (fear of missing out). Especially if you have friends or family members who are bragging about how much they made investing in a certain stock.
But this could put you in a place where your investments aren't in line with your goals. And when your main motivation for investing in something is because of greed rather than your goals, it could be your major downfall.
1. It can make you buy high
When greed takes over and you fear missing out on investment growth, jumping on an investment bandwagon may be tempting. The issue with bandwagoning, though, is that the stock may be trading at a high and positioned for a correction. And if this happens, you may end up buying your stock or mutual fund just before it drops in price, and it could take a while before you see subsequent increases.
For example, a stock like Netflix (NFLX 2.64%) did very well in 2020 and went from a price of $324 per share at the beginning of the year to $541 at the end of the year -- a 67% increase. But if you'd bought this stock at the beginning of 2021, you would've experienced a year-to-date loss as the stock recently traded at $507. When this happens, you may find yourself frustrated with your purchase. And depending on how long it takes you to recoup your initial investment, you may even give up on it if you've only seen it lose money since owning it.
But a stock that is trading at a high may also continue trading higher. And if you're waiting for a drop in price so that you can buy it at a discount, you could also be making the mistake of trying to time the market. Dollar-cost averaging can help you avoid this. When you use this strategy, you buy predetermined amounts of an investment over equal increments of time rather than investing it all as one lump sum. Some of the shares you will buy at higher prices and some at lower prices. But overall it will help you get invested while avoiding putting everything you own in the stock market just before it collapses or missing out on further appreciation in price.
2. It can make you take on too much risk
When you are earning money on your investments, it can feel really good. And your accounts increasing in value can make you feel as if you're more comfortable with risk than you really are. But how you feel about losing money can be a better indicator of your risk tolerance than when you are gaining money.
If you invested $100,000 in large-cap stocks at the beginning of 2003, you would've seen your accounts increase to nearly $183,000 by the end of 2007. But that same account would've been cut to $115,000 when the stock market crashed in 2008. If you would've felt uncomfortable with this decrease in value, then a portfolio made up of 100% stocks may be too aggressive for you.
You can take a simple quiz that will help you get a better understanding of your appetite for risk. It will take into account important things like how much time you have before you need your money and your age. But also how you feel about volatility and how you've reacted to it in the past, which can help gauge your comfort level with more aggressive securities.
3. It can make you deviate from your asset-allocation model
In 2020, the Nasdaq Composite Index outperformed other benchmarks like the S&P 500 and the Dow Jones Industrial Average. The Nasdaq has a heavy weighting in tech stocks, which have fared better than other sectors during the COVID-19 pandemic. It finished the year up 43%, whereas the S&P 500 was up only 16% and the Dow Jones was up just 7%.
It may seem like a good idea to load up on this sector, but you can put yourself at an increased risk of losing a lot of money if that sector is hit hard. For instance, from 2000 to 2002, the Nasdaq suffered much more severe losses than the S&P 500 because the Nasdaq included a disproportionate number of stocks affected by the dot-com crash.
Because you have no way of telling which asset class or sector will do well from year to year, diversification can help you reduce this risk. Having an asset-allocation model that includes a little bit of everything can help you ensure that you have some exposure to different asset classes or sectors when they do well but not too much when they perform poorly.
Buying the next best thing can be fun. But how you invest should take into account more than just how much a certain investment can grow. It should also consider things like your goals, investment horizon, risk tolerances -- and making sure your purchases fit in well with your account objectives.