Stocks are by far the best class of assets to own if you hope to build wealth over a long period of time. And, there is no magic formula to success -- simply buy a diverse mix of high-quality companies and leave them alone. However, there are several mistakes new investors (as well as some with experience) make that can be devastating to your wallet.
Mistake 1: Day trading
People who are new to the market often plan to "day trade" their accounts and make big profits. Day trading refers to the act of opening and closing stock positions within a trading day, with the hopes of making quick profits from small intraday price movements.
This is usually a bad idea, as most day traders lose money, even those with a solid strategy and good money management skills. One of the main reasons is that day trading is expensive.
Let's say that you make 20 round-trip trades on the average day, and there are 250 trading days in a year. This translates to a total of 5,000 trades, or 10,000 individual buy or sell trades. Assuming that your discount brokerage charges about $10 per trade, you'll spend $100,000 on commissions alone each year. In other words, you could be a good trader and make a six-figure profit, and still potentially lose money.
The odds are stacked against day traders -- leave trading to professionals and be an investor.
Mistake 2: Speculating with options
Options can certainly have a place in a long-term investing strategy. For example, selling call options against stock positions you own can provide some downside protection and also produce a nice income stream. There are other, more complex strategies that can be good ideas too.
However, newer investors are often tempted to speculate on out-of-the-money options in the hopes of making tons of money in a short time period. The problem is, most of the time these trades don't pan out, and the "investor" loses all of their money.
For example, as of this writing, Apple stock is trading for approximately $96 per share. A quick look at Apple's option chain shows me that I can buy options to buy Apple for $105 per share anytime between now and February 19 for a premium of $0.95. This may sound like a great idea. After all, if Apple hits $110 anytime between now and then, I can sell my options for at least $5.00 and earn more than 400% returns in a month.
If something sounds too good to be true, it probably is, and that's certainly the case here. Is there potential for massive profits with a trade like this? Sure. Is it likely? Not at all.
Mistake 3: Panic selling and greedy buying
Did you know that over the past three decades, the S&P 500 has produced total returns of about 9% per year on average, but the average investors returns were a paltry 1.9% during that time period?
The reason is simple. We all know that the point of investing is to buy low and sell high, but most investors do the exact opposite. When their stocks take a dive, they panic and sell in fear of losing even more money if they hold on. And when stocks seem to go up and up forever, that's when most investors are tempted to throw their money in, buying near the top.
The best course of action is to buy quality stocks without regard to what the market is doing, and then hold on for the long haul, even if your stocks go down. While admittedly this mistake won't make you lose all of your money, but I mention it here because it's one of the most important lessons you can learn if you hope to be a successful long-term investor.
Mistake 4: Buying penny stocks
I would think that after people see movies such as The Wolf of Wall Street, they would never be talked into buying penny stocks. On the contrary, the sad reality is that many people voluntarily seek these stocks out. Sadly, there are plenty of advertisements out there that promise things like "500% gains on our average penny stock pick."
Are there any penny stocks that have gone on to make average investors rich? Perhaps, but rarely. The truth is that too many of these stocks, many of which trade for as little as $0.0001 per share, are pump-and-dump scams, plain and simple.
What happens is that a company will hire a PR firm to get the stock positive coverage in the media. It will pay analysts to write positive coverage and will pay media outlets to cite the analysts' work. There was a particularly unfortunate case a few years ago where a company known as Goff, which hadn't earned a dime, ended up getting major media coverage, and many unsuspecting investors took the bait and bought shares as high as $0.65. The stock fell sharply afterwards and now trades for just $0.0008.
Instead of trying to get rich quick with penny stocks, stick to solid companies when formulating your investment strategy, or at least buy companies because you know and love their business.
The best way to get rich in stocks is slowly
To sum it up, just about anything you can do in the stock market that has a goal of big, quick profits is most likely a bad idea. You can get rich in the market, but do yourself a favor and do it the best possible way -- by aiming for a series of base hits instead of swinging for the fences.