No one invests in the stock market to lose money. Yet it often seems like the people who lose their shirts outnumber those who strike it rich. While there's no guaranteed way to avoid losing money in the market, recognizing these six common blunders can save your portfolio from a lot of pain.
1. Not knowing what you're buying
Legendary investor Peter Lynch popularized the idea of buying "what you know." While this doesn't mean that you should buy Apple (NASDAQ:AAPL) stock because you like the iPhone, it could be a viable starting point for additional research.
Unfortunately, many investors buy stocks in sectors that they don't understand, simply because financial pundits recommended them. That's a reckless strategy which leads to impulsive purchases and sells, since these investors can't grasp the longer-term headwinds or catalysts for a company.
2. Not keeping up with quarterly reports
Warren Buffett was once asked how investors can make smarter decisions. He reportedly held up stacks of reports and said, "read 500 pages like this every day. That's how knowledge builds up, like compound interest."
Unfortunately, Investors sometimes don't keep up with a company's most recent quarterly reports and conference calls. As a result, they fail to understand why a company beat or missed expectations during the quarter, and become oblivious to upcoming headwinds or catalysts. That's why I think an ideal portfolio consists of less than 20 stocks -- any more and I find it hard to do my due diligence on each company.
3. Ignoring forecasts and valuations
Many short term traders rely on the murky notion that the "trend is your friend." This basically means following trading volume and price fluctuations while ignoring a business' fundamental growth and valuations. But if you do that, you violate the core tenets of long-term investing -- to understand how fast a company is growing, and to determine if a stock is cheap based on that growth.
If we look at Apple, we'll see that analysts expect its sales and earnings to respectively grow 6% and 8% this year. That's not bad for a mature tech company, but its trailing P/E ratio of 17 currently matches its industry average of 17 -- which tells us that the stock isn't really "cheap" at current prices. Yet the short-term trader might still buy the stock, believing that the stock rising above historic highs indicates that the stock is "breaking out."
4. Applying trading strategies to long-term investments
Investors also often confuse short-term trading strategies with long-term ones. A classic example is the trailing stop, which automatically sells a stock once it drops by a predefined amount or percentage. That sounds like a smart move -- the trailing stop rises with the stock, and "catches" it on the way down, removing all emotion from a trade.
But in reality, setting trailing stops under long-term investments can cause premature selling. If we revisit Apple, we'll see that the stock fell from the mid-$20s to less than $12 during the financial meltdown of 2008-2009. A trailing stop would have prevented your stock from falling to $12, but you would have missed the rally all the way back to the low $140s. If you were a true long-term investor, you would have been buying up more shares instead of selling.
5. Selling winners and holding losers
Investors naturally want to sell their winners and hold onto their losers. That's because they're constantly afraid that their gains will be erased, and always hopeful that they can recover their losses.
History shows us how disastrous selling winners can be. If you had invested $10,000 in Amazon's (NASDAQ:AMZN) IPO in 1997, you would have received 555 shares. After three splits in 1998 and 1999, your share count would have risen to 6,660. That stake would be worth $5.8 million today. Imagine how you would feel if you had sold that stake the first time it doubled, tripled, or even quadrupled.
As for losers, check out BlackBerry (NYSE:BB), which lost 95% of its market value over the past decade. Investors who believed that the former smartphone market leader would make a comeback (in phones, tablets, or software) were repeatedly burned by lofty promises.
6. Failing to diversify
Lastly, the easiest way to lose money in the stock market is to not diversify. Having a single hot stock account for 100% of your portfolio might be great when that stock goes up, but you'll be in big trouble when it comes tumbling down.
Likewise, buying a lot of stocks from a single sector doesn't count as diversification, since bad news about one company often drags down its industry peers. Therefore, I generally spread my stocks out over a few sectors, and I don't allow a single stock to account for over 10% of my portfolio.
The key takeaways
The stock market can be tough for unprepared investors. But if you try to avoid these six common pitfalls, I think you'll stand a better chance at growing your investments instead of losing all your hard-earned money.