There's no such thing as a perfect investor. Even the most seasoned investing experts make bad investments every now and then. However, good investors understand that some fundamental mistakes can (and should) be avoided to make you a better investor.
Here are five painfully common investing mistakes to avoid.
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1. Underestimating the power of compounding
In investing, one of the best resources on your side is time -- the earlier you begin investing, the better. Time is so important because of compounding, which occurs when your investment returns begin to earn returns of their own.
To illustrate the power of compounding, let's imagine a scenario where your investments return 10% annually (the historical average annual return of the S&P 500). If you contribute $500 a month, here's how much you'd roughly accumulate at different points in time:
| Monthly Contribution | Years | Account Total |
|---|---|---|
| $500 | 10 | $95,600 |
| $500 | 15 | $190,600 |
| $500 | 20 | $343,600 |
| $500 | 25 | $590,100 |
| $500 | 30 | $987,000 |
Chart and calculations by author.
In this scenario, although it will take 10 years to potentially accumulate $95,000, it will take only five more years to almost double that amount. Although you managed to gain $153,000 in the five years between year 15 and year 20, in the five years between year 25 and year 30, your investment will possibly gain over $396,000. That showcases the true power of compounding.
2. Ignoring an index fund's expense ratio
Even though you won't be charged to purchase an index fund, you'll pay an expense ratio, which is charged annually as a percentage of your total investment. If an index fund has a 0.50% expense ratio, you'll pay $5 per $1,000 that you invest. If the expense ratio is 0.25%, you'll pay $2.50 per $1,000 invested.
A small difference in percentages may not seem like much but can really add up over time. Just a difference in a quarter of a percentage point can add up to tens of thousands in the long run.
3. Keeping up with a stock's daily price movement
The only thing guaranteed in the stock market is volatility. No matter how great a business is, you can expect its stock price to fluctuate -- that's just how it works.
If you're a long-term investor, a stock's daily price movements shouldn't affect you or change your attitude toward the investment. If you're investing in fundamentally sound businesses, you should be able to trust that they'll produce great returns over the long term, even if they're having a rough time in the short term.
4. Equating price with cheap or expensive
You shouldn't look at a stock's price by itself to determine whether or not it's cheap or expensive. It could very well be the case that a $20 stock is expensive and a $1,000 stock is cheap. Investors should use other metrics to determine whether or not a stock is a good value at its current price.
One common metric to determine a stock's value is its price-to-earnings (P/E) ratio, which compares a company's stock price to its earnings per share (EPS). Calculating a company's P/E ratio and comparing it to similar companies is one way to help determine if it's overvalued or undervalued.
5. Ignoring dividends
Outside of an increase in a stock's price, dividends are the other primary way to make money from an investment. While younger companies tend to not pay dividends because they need to reinvest the money back into the company to continue growing, older, more established companies typically pay out dividends because they likely have less room for hypergrowth in their stock price. It's a way to reward shareholders for holding onto their investments.
If you consistently buy dividend-paying stocks, you can set yourself up to have a decent amount of income coming in, both now and in retirement. Along with retirement accounts and Social Security, dividends can play a huge role in supplementing your retirement income. In some cases, it can be thousands monthly.
