4 Things to Avoid as a New Investor
Avoiding these rookie mistakes can save you lots of money and frustration as you learn how to invest.Image source: Getty Images.
There’s an extensive list of mistakes that investors can make, and they range from mild to potentially devastating. New investors without a strong knowledge base are particularly vulnerable to making “rookie mistakes,” and while a learning curve is to be expected after you open your first brokerage account, avoiding these four common mistakes could save you lots of money and frustration.
1. Day trading
Many new investors think that day trading -- which is moving in and out of stock positions in hours or even minutes -- is the best way to make money in the stock market. After all, they’ve seen stock traders depicted in movies as nothing but a bunch of rich people with yachts, sports cars, and mansions.
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However, the reality is that most day-traders lose money. According to one research report, only 13% of day-traders earn a profit in a given year, and less than 1% are consistently profitable.
One big reason is trading costs. Let’s say that you pay a $6.95 commission per stock trade. If you make 10 round-trip trades every day for about 250 trading days in a year, this adds up to nearly $35,000 in commissions. That means you’re starting at a big disadvantage and would need to profit $35,000 just to breakeven. Leave day-trading to the pros and focus on long-term investing instead.
You may be surprised to learn that over the 30-year period ending Dec. 30, 2016, the S&P 500 averaged a 10.16% total return per year, but the average stock fund investor managed less than 4%, according to Dalbar.
One big reason for that is the tendency to overtrade. Everyday investors tend to move in and out of stock positions far too often, and human nature encourages them to do it at the worst possible times. When everyone else is making money and stocks are expensive, they shove as much money as possible into the market. Then, when the stock market is crashing and stocks are cheap, they sell “before things get any worse.”
Don’t make this mistake. Instead, buy stocks you plan to hold for the long term unless something fundamentally changes that makes selling a good idea.
3. Buying Options
Options give you the right to buy or sell a specific investment at a certain price at any time before its expiration date.
To be clear, options can be excellent tools when used properly by experienced investors. In fact, I use options frequently as part of my strategy. However, I strongly suggest steering clear of options until you really know what you’re doing.
One common mistake new investors make is buying call options that are way out of the money, meaning options that give the right to buy a stock at a price that’s significantly higher than the current share price. Without getting into a lengthy options discussion, these are options contracts that trade cheaply, but the underlying stock would need to move quite a bit before it would be worth anything.
For example, let’s say that Stock XYZ is trading for $50. I could buy an option for $1 that would allow me to buy it for $75 at any time between now and the end of the year. If the stock rises to $100, this option would be worth $25 -- the difference between the stock’s value and the price you can buy it for. However, if the stock doesn’t rise to at least $75, which would be a big move, it would be worthless. This is like buying a lottery ticket. Don’t make the mistake of gambling with your investment portfolio.
4. Investing with margin
Investing with margin means investing with borrowed money. For example, if you have $5,000 in your brokerage account and want to buy $7,000 in stock, your brokerage may be willing to loan you the additional $2,000, which will be backed by the securities held in your account.
This is generally a bad idea, no matter how experienced of an investor you are.
Let’s say you have $5,000 of cash in your account and you use it to buy a certain stock. If the stock drops by 50% in a crash, your investment will still be worth $2,500, and you can leave it alone to (hopefully) rebound over time. Not a great scenario, but not a death sentence for your portfolio either.
On the other hand, let’s say that you have $5,000 cash and borrow another $5,000 to buy a total of $10,000 of stock. If the stock drops by 50%, you’ll be down by $5,000 and will be totally wiped out. Plus, because you’ll no longer have collateral in your account, your broker will issue what’s known as a “margin call” and force the sale of your shares -- so you won’t even be able to hold on and hope they rebound.
The bottom line is that losses are bad enough. Don’t magnify them.
Mistakes are inevitable, but avoid the big ones
To be clear, all investors make mistakes. They sometimes buy stocks based on faulty analysis, hold on to losing stocks for too long, and often don’t keep enough cash on the sidelines to take advantage of market corrections.
However, all of these are minor mistakes that can actually help make you a better investor over the long run. As a personal example, I learned a great deal by buying Telsa stock for less than $25 and selling it for a little more than twice that amount (it’s now worth about $350).
Mistakes are a natural and valuable part of your learning curve as an investor, so don’t live in fear of making them -- you’re going to, sooner or later. By avoiding these big mistakes, you’ll be able to learn from your minor errors as you go and will be able to evolve into a seasoned investor before you know it.
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