Investing in stocks is one of the most effective means of accumulating wealth. Yet nearly half of the U.S. adult population steers clear of stocks despite the opportunities at hand, and the reason often boils down to fear.
That fear is not irrational. The stock market is unquestionably volatile, and if you work hard for your money, as most of us do, the last thing you want to do is risk losing it. On the other hand, if you're smart about how you invest in the stock market, you'll minimize that risk and increase your chances of coming away a winner. With that in mind, here are five pitfalls that increase your odds of taking a major loss at some point or another.
1. Assume you'll get your timing down pat
Many investors think they can maximize their profit by timing their purchases just right. But studies have shown over and over that timing the market just plain doesn't work. No matter how confident we are, or how many so-called indicators suggest that the market is about to move one way or another, we simply don't know what the market will do next.
The stock market can be erratic, and the only thing we know for certain is that it will experience ups and downs (although it has historically averaged returns of about 7% per year). Every investor wants to buy low and sell high. However, the lows and the highs are nearly impossible for us to identify. A stock that you think has bottomed out could drop even further, and if you sit around waiting for a rising stock to fall before you buy it, you could be waiting forever -- and missing out on incredible gains.
You can do your research and aim to invest at just the right time, but just know that the overwhelming majority of investors who take this approach wind up failing at it. In general, you're better off simply buying shares of great companies and holding on to them for years or decades, riding out (and largely ignoring) the market's ups and downs.
2. Be reactive
It's easy to get nervous when the stock market takes a tumble and your investments lose value overnight. But if you react to bad news by panicking and selling off your positions, you're more likely than not to lose money. One thing many investors fail to realize is that there's a difference between a "paper loss" and a real financial loss. If your portfolio drops but you don't sell your stocks, then you're only looking at a loss on paper. You won't actually lose one cent of actual money until you start selling your stocks.
When the market dips, you need to keep your head and stick to your strategy. Odds are, the market will not only recover, but eventually rise far beyond its previous highs -- just like it has after every market crash in history.
3. Be shortsighted
The idea of making a quick buck in the stock market certainly has its appeal. But if your goal is to invest and get out quickly, you're likely to lose out. That's because the stock market experiences frequent corrections, which are periods when values fall 10% or more. Since 1950, there have been 34 distinct corrections, and if your exit strategy happened to coincide with one of them, you would've no doubt lost money.
But here's the thing: Though corrections are fairly common, we've historically spent more time in up markets than in down markets, as evidenced by the fact that the stock market recovered from each and every one of the aforementioned 34 corrections. In other words, if you're willing to invest for the long haul, you're likely to come out ahead. Impatience is one of an investor's greatest enemies.
4. Don't diversify
Loading up your portfolio with nothing but individual stocks could backfire if you're a rookie investor. The same holds true if you put all of your money into the same sector, as opposed to spreading your money out over different industries. A smarter approach is to maintain a diversified stock portfolio, which will help protect you from sector- or company-specific fluctuations. As part of this strategy, you can fill your portfolio with index-tracking exchange-traded funds, or ETFs, which simply mirror the returns of broad market indexes. It especially pays to get started with ETFs when you're a newbie, though they make good core holdings for seasoned investors as well.
5. Go heavy on penny stocks
At first glance, penny stocks, which are those valued at less than $5 per share, may seem like safe investments. After all, you're not sinking a ton of cash into each individual share, which means you're less likely to lose money, right? Wrong.
Penny stocks are typically issued by less established companies and don't trade on a public exchange. When you buy penny stocks, you're generally not getting a ton of information about the underlying companies. Furthermore, companies whose stocks don't trade publicly aren't subject to the same financial requirements as those that do, which means that as an investor, you're much less protected from losses.
When it comes to stock investments, the above-listed errors are more common than you'd think. Avoid them at all costs, and you'll increase your odds of coming out ahead. The best news of all is that the best method of investing in stocks also happens to be simple: Buy a diverse array of high-quality stocks and hold them for years -- preferably until you've reached your investment goal, whether it's purchasing a new home, retiring in comfort, or any other financial dream of yours.