Investing in stocks is a great way to grow wealth, especially if you assemble a solid portfolio and leave it invested for many years. But if you're new to investing, it's easy to fall victim to certain pitfalls that could set you back financially. Here are five you should make every effort to avoid.
1. Investing before you have a solid emergency fund
You never know when an unplanned bill or layoff might be in your future. And so you need money in the bank to allow for that possibility -- enough to cover a good three to six months of essential living expenses.
It's important to have a solid emergency fund before you start investing. If you don't have money in the bank and stock values tumble, you may have no choice but to liquidate investments at a loss when a need for money arises.
2. Investing money you might need for a near-term goals
As a general rule, you shouldn't invest money in stocks you think you'll need within seven years. That's because the stock market can be volatile, and it can take time to recover from a major crash.
If you're looking to buy a home in the next three years, or you're socking away money to start a business within five years, you probably don't want to put it into the stock market. Rather, in that case, it pays to explore alternatives, like bonds or bond ETFs, which may be less volatile.
3. Choosing stocks at random
Without a crystal ball, it's impossible to say with certainty how different stocks will perform over time. A company with solid financials right now could fold in 10 years, dragging your portfolio value down with it.
But still, there are steps you can take to research stocks and figure out which have the most value and growth potential. And it pays to make that effort rather than choose stocks at random and hope for the best.
4. Choosing stocks because they're cheap
A low share price doesn't make a stock a good buy, nor does a high share price make a stock a bad buy. Penny stocks, for example, are easy to acquire since they typically trade for less than $5 per share. But they can also be very speculative, which means they're often riskier than stocks that are more expensive on a per-share basis.
5. Letting emotions guide your decisions
When you're new to investing, it can be tough to see your portfolio decline from one day to the next due to movement in the market outside your control. But remember, you don't officially take losses in your portfolio until you sell off investments for less than what you paid for them.
That's why it's important to keep your cool and avoid reacting when stock values plummet. If you sit tight and ride things out, you can avoid losses.
Similarly, don't rush to sell stocks at a profit when their value rises. Doing so could mean missing out on future gains, not to mention opening yourself up to taxes you may not be prepared for.
If you've yet to start investing, the best time to begin is right away. Just make sure to avoid these traps as you navigate the process of building your portfolio.