It's easy for a beginning investor to make mistakes out of exuberance, impatience, or even ignorance. But those mistakes can be costly, making them well worth avoiding.
In order to increase your gains and decrease your losses, it's important to get a little savvy before you start investing. By the time you're done with this article, you'll have a better idea of what kind of temperament you'll need, what expectations are reasonable to have, and what strategies will serve you best. The more you know, the better you can do.
Here are 20 common beginner-investor mistakes -- and how to avoid them.
No. 1: Investing before you're ready
First, never invest until you're ready to, and that means financially, as well as mentally.
Pay off your high-interest-rate debt before you start investing. If you're deep in debt and paying, say, 18% in interest annually (which is not an unusual rate), any money you spend on stocks would have to earn more than 18% just to keep you from losing ground. Over long periods, the stock market's annual returns have averaged close to 10%, not 18%, with many periods featuring significantly less than that.
It's also smart to have a fully stocked emergency fund in place before you start putting money in stocks. Aim to have six to 12 months' worth of living expenses easily available. Without an emergency fund, a costly car repair or unexpected medical bill can force you to sell your stocks at a bad time -- such as when they've temporarily fallen in value -- causing you to lose out on future gains.
No. 2: Setting unrealistic expectations
Building wealth through the stock market can take time, and dreams of quick gains can be quickly dashed. For example:
Never put any money into stocks that you may need within the next five years because the market occasionally swoons and can take a few years to recover.
Have reasonable expectations for stock market investing. For instance, the market's long-term average annual return is close to 10%, but some years it can surge 25% or more, while it can drop by 25% or more, too. Expect volatility, and know that few stocks will deliver long-term average returns of more than 20%.
No. 3: Trusting the wrong people or sources
Many new investors put too much faith in talking heads on financial TV programs or in hot stock tips offered by a friend or colleague. Anyone can recommend a stock, but you rarely really know the track record of the recommender -- and even a great investor will make some bad calls. Investors can also be fleeced by cold callers who interrupt an evening with an urgent appeal to put money into a one-of-a-kind, can't-lose investment, perhaps a company supposedly on the verge of curing cancer or striking gold or oil. Remember, anything that sounds too good to be true most likely is.
No. 4: Buying into investments you don't understand
You know that Amazon.com operates the massive e-commerce site that bears its name, and you probably know that it also sells devices that use its Alexa artificial-intelligence technology. But you might not know that its fastest-growing division is its cloud-computing service, that it's developing a game-streaming service, or that it's planning to open some 3,000 cashier-free convenience stores around the country. If you invest in Amazon (or any company), you really need to have a good handle on exactly how it makes its money, what its competitive advantages and risks are, how financially healthy it is (in terms of cash vs. debt), and how rosy its future seems to be.
Some industries, such as retail and transportation, can be easier to understand than others, such as biotechnology and financial services.
No. 5: Paying too much in commissions
Once you start actually investing, take care to not spend too much on trading commissions, which are the fees your brokerage charges for each buy or sell order you place. Aim to pay no more than about 2% of the value of your trade in commissions. For example, if you were placing a $1,000 trade, you'd spend no more than $20 on commissions. Many good brokerages these days charge $7 or less per trade, so you can make relatively small trades and not exceed 2%.
A $7 commission would be 2% of a $350 trade. If you placed a $100 order, though, a $7 commission would represent 7%, and you'd need your investment to grow by a full 7% just to break even.
No. 6: Trading too frequently
It's easy to find yourself trading too often when you're just starting out. Maybe you'll buy into a handful of exciting companies ... but then you'll spot some other exciting companies, so you sell some shares of the first batch of companies and buy into some others. This is a good way to rack up trading fees (see No. 5). And it might cost you more in taxes -- if you sell your stocks within a year of buying them, they may be taxed at the short-term capital-gains rate, which is higher than the long-term rate.
But beyond that, you need to give great investments time to grow -- ideally, many years. And if you find yourself losing confidence in the stocks you buy, that could be a sign you're not studying them enough before you buy.
Not convinced yet? Well, according to an academic study of frequent traders between 1992 and 2006, fully 80% of active traders lost money and "only 1% of them could be called predictably profitable."
If you trade multiple times an hour or day, you're a day trader, and that's especially risky. No less an authority than the Securities and Exchange Commission (SEC) has warned against day trading, noting: "Be prepared to suffer severe financial losses. Day traders typically suffer severe financial losses in their first months of trading, and many never graduate to profit-making status."
No. 7: Buying penny stocks
Penny stocks are stocks trading for less than about $5 per share, and many are priced well below $1. The fact that you can grab thousands of shares for a few hundred dollars (or less) can be appealing to beginners. That's trouble because penny stocks are often tied to unproven, unprofitable, and sometimes shady companies. They're also frequently very volatile and easily manipulated by scammers.
Scammers buy shares of the stock, hype it up online or in newsletters so that others buy in and drive up the price -- and then the scammers sell their shares, causing the price to plunge, leaving the other investors with big losses. It's called a "pump-and-dump" scheme.
A stock priced at just $1 per share is not necessarily a bargain and can be more likely to fall to $0.50 or $0.10 per share than to double or triple. Meanwhile, a $300 stock can be a bargain, doubling or tripling within a few years.
No. 8: Putting too many eggs in one basket
If your money is invested in just a few stocks, you have less room for error if something goes wrong. There's an upside to what you're doing, of course: If your money is in just one stock and that stock doubles, your portfolio doubles! But if the stock drops by 40%, so does your whole portfolio. There's no perfect number of stocks to own, but having fewer than 15 or so can have you taking on too much risk.
You shouldn't necessarily aim to own 50 or 100 stocks, either, as that can mean that any single stock soaring won't have too much of an impact on your overall portfolio. And the more you own, the harder it will be to keep up with each holding. For many people, 10 to 20 different stocks is a reasonable number.
No. 9: Not diversifying sufficiently
Not diversifying enough is another common investing blunder, and it's not necessarily addressed by you owning, say, 20 different stocks. If 10 of those are energy companies and 10 are manufacturing-focused companies, you're not that diversified. A sudden drop in the price of oil or gas could change the fortunes of half your portfolio, as could a recession that has manufacturers slowing down.
Aim to be invested in a range of industries -- and ideally, a range of countries, too. Go ahead and focus on U.S.-based stocks, but consider adding some international holdings, too -- or some big U.S. companies with sizable foreign operations.
No. 10: Buying, selling, or holding stocks based on emotions
Too many new investors (and many seasoned ones, too) will buy shares of companies based on excitement and even greed, with insufficient attention paid to how undervalued or overvalued the stocks are. That's risky, because overvalued stocks are more likely to suffer big setbacks than undervalued ones.
Many investors will also sell in a panic if the overall market drops or if one or more of their stocks do. Know that the market and individual stocks will always go up and down. Expect the market to be at least somewhat volatile, and brace for a downturn every few years -- knowing that the market has always rebounded after downturns. (This is why you shouldn't invest with any money you'll need within a few years.)
If an individual stock falls, figure out why it's happening. If it's a short-term reason, such as a fire at a manufacturing plant or temporarily high prices for its raw materials, consider hanging on. If the company seems to be facing long-term challenges, such as a powerful new competitor, a big accounting scandal, or adverse regulations, consider selling.
Try to keep emotions out of your investing and be as rational as you can.
No. 11: Expecting past performances to continue
If you're looking for some stocks or mutual funds in which to invest, it can be hard to resist those that have had a very strong year, perhaps surging 60% or more or even doubling in value. Know, though, that such great performances don't automatically repeat year after year -- especially with mutual funds. A quickly growing company might see its stock surge for several years in a row, but that's not guaranteed. And a mutual fund's huge gain can turn out to be an outlier.
It's OK to hope for great performances from your investments, but don't count on them or assume that you'll get them every year.
No. 12: Not making use of index funds
It takes a lot of work to become an investor with a successful track record of picking great individual stocks and holding them while they grow over many years. It requires a lot of reading, learning, thinking, deciding ... and some luck, as well. Many of us don't have the time or interest for all that.
For most people, it's best to just invest in a low-fee, broad-market index fund, such as one based on the S&P 500. That will get you roughly the same returns as the overall stock market. Consider, then, index funds such as:
- The SPDR S&P 500 ETF (NYSEMKT:SPY) distributes your assets across about 80% of the U.S. stock market.
- The Vanguard Total Stock Market ETF (VTI) invests your money in the entire U.S. market.
- The Vanguard Total World Stock ETF (VT) plunks its investors' cash in just about all of the world's stock market.
Investing all or most of your money in index funds is a very reasonable choice, in part because index funds tend to outperform most managed mutual funds. According to the folks at Standard & Poor's, for example, as of the middle of 2018, 84% of all domestic stock mutual funds underperformed the S&P 1500 Composite Index over the past 15 years, while 92% of large-cap stock funds underperformed the S&P 500.
No. 13: Not evaluating your performance
Speaking of outperforming benchmarks, we investors should be assessing our own performance regularly. Since any of us could invest in a good low-fee S&P 500 index fund, if we're investing in individual stocks, it makes sense to aim to outperform the S&P 500 index. If we don't do so over a period of years, we'd do better just keeping our money in the index fund.
Don't throw in the towel after just a single year (or maybe two) of underperformance, though, but try to assess how well you're doing over a few years. If you keep reading and learning about investing, you may refine your strategies for the better over time, too.
No. 14: Not keeping up with your investments
If you've invested in a bunch of stocks, even if you sensibly plan to be a buy-and-hold investor, you shouldn't just forget about them. For best results in your investing, you should keep up with them -- at least quarterly, for most. Check out their quarterly financial reports and look up what management has been saying about the company's performance and strategy. As the years go by, evaluate how well management has been executing its strategy.
Look the company up in the news, too, to see what you can learn. If there are big developments, such as new-product launches or shrinking sales, you'll want to know about them.
No. 15: Not rebalancing your portfolio
This problem often happens without your even noticing it. First, you buy securities for your portfolio in the proportions that you want. For example, maybe you've got 75% of your portfolio in stocks and 25% in bonds. Five years later, though, your stocks may have grown to make up 85% or 90% of your portfolio -- more than you wanted to hold. You are overdue for a portfolio rebalancing. You need to sell some of your stocks and buy more bonds to re-establish the stock-bond proportions you want.
The problem can also happen just with stocks. If you hold, say, 15 different stocks and one of them has soared, it might now make up 20% of the value of your portfolio. If so, that's generally too much for any one stock holding, so you'd do well to sell some of those shares and redistribute the money. (Note, though, that great wealth is often built by letting great stocks keep growing -- so do stay invested with a meaningful sum, as long as the company is healthy and growing and you retain confidence in it.)
No. 16: Buying more of a fallen stock
This can seem counterintuitive. It's true that if the broader stock market swoons, that can be a terrific time to pick up shares of great companies. But that doesn't mean that if an individual stock plunges in value, you should snap up more shares.
Stocks often plunge for a good reason. Before buying any more shares, do some digging into what's going on. You might actually determine that you'd do well to sell the stock. Don't buy more shares unless you're quite sure that whatever problem the company is facing -- perhaps the departure of its CEO or a disappointing earnings report, for example -- is a temporary one.
No. 17: Waiting for an unlikely rebound and not selling a bad stock
What would you do in this situation: You bought shares of a stock a while ago, and they've dropped in value. Let's say that you bought 50 shares at $80 apiece, for $4,000, and now the stock is at $60 and your investment is worth just $3,000. You're thinking of selling the shares, as you've lost confidence in the company, but you're looking at realizing a $1,000 loss if you sell.
Many investors in this scenario would stubbornly hang on, not wanting the $1,000 loss. They will decide to wait for the shares to gain at least enough to wipe out their loss -- and then they'll sell and move the money elsewhere. That's not a smart move, though, because remember -- they have little faith in the company now. If it doesn't seem likely to grow in value very soon or very much, why wait for the unlikely to happen?
Instead, sell the shares, take your loss, and move the remaining $3,000 into a stock in which you have more confidence. Your money is more likely to grow in value there, and you might be able to make up the lost $1,000 in this more promising company.
No. 18: Investing with borrowed money
Once you hear about investing with borrowed money -- i.e., using "margin" -- you may get excited at the prospect. Here's why it's exciting: Imagine that you invest $10,000 in a stock and it gains 50%, and now it's worth $15,000. Great, right? But what if you'd borrowed $10,000 and invested a total of $20,000 in the stock? Then you'd have $30,000!
Using margin is perfectly legal and can greatly amplify your gains -- but it can amplify your losses, too. In the example above, if the stock you borrowed money to buy falls by 50%, your $20,000 stake in it will be worth $10,000 -- the sum you borrowed. Once you pay it back, you'll be left with $0 -- meaning that 50% loss became a 100% loss, thanks to margin.
Also, the equity in your account is the collateral that you're putting up for the loan. If the value of your investments made on margin start falling significantly, you'll get a "margin call" from your broker asking you to sell some assets to generate cash or to deposit more cash into your account. If you fail to do so, the brokerage may just sell some of your holdings for you.
Meanwhile, brokerages charge you interest to use margin. At one major brokerage, for example, the recent rates ranged from 8.075% if you borrowed $250,000 to $499,999 to 9.825% if you borrowed less than $25,000. You'll need to earn quite a high return to make the borrowing worthwhile. Margin is best avoided, for most investors.
No. 19: Trying to time the market
Another common investing blunder is engaging in market timing -- getting in and out of the market based on whether you think it's heading up or down. This might seem reasonable, especially if you listen to the investing gurus who say they know where the market is headed in the near future. But identifying the best or worst days in advance is easier said than done, and guessing wrong can cost you. Researchers at Morningstar.com found that over the 20 years from 1992 to 2011, the market averaged 7.8% annually. If you were out of the market on the 10 worst days in that period, you'd have averaged 12%, while if you were out during the 10 best days, you'd have averaged 4.1%.
Index-fund pioneer John Bogle has quipped: "Sure, it'd be great to get out of stocks at the high and jump back in at the low, [but] in 55 years in the business, I not only have never met anybody who knew how to do it, I've never met anybody who had met anybody who knew how to do it."
No. 20: Not continuing to learn
The more you know, the fewer mistakes you'll likely make. And your reading and thinking may lead you to better investing strategies and better performance, too.
Read about great investors. Read about great businesses. Read about business failures, too, as they can be quite instructive. Read about great management styles, as the best businesses will have great management. Read up on industries that interest you, learning about their challenges, their prospects, and which players are strongest and weakest.
Remember this quotation from Warren Buffett's longtime business partner, Charlie Munger:
In my whole life, I have known no wise people (over a broad subject matter area) who didn't read all the time -- none, zero. You'd be amazed at how much Warren reads -- and at how much I read. My children laugh at me. They think I'm a book with a couple of legs sticking out.