In this article, we will explore 10 common stock market mistakes – and how to avoid them.
Investing in the stock market is much harder than it appears. Beginners often get carried away and let emotions, impatience, and ignorance dictate their investment decisions. Unfortunately, this can cost you a lot of money.
If you want to maximize your gains and minimize your losses, you must adopt the right mindset and learn how to invest properly.
The more you know, the more you’ll earn.
Here are 10 common investing mistakes – and how to avoid making them.
1 – Investing Before Being Ready
The first mistake beginners make is investing before being financially and psychologically ready.
Here are three important criteria you can use to evaluate whether or not you are ready to invest.
- Pay off your high interest debts
If you have high-interest debts – meaning debts with interest rates of 10% or more – you should pay them off before you inject a single penny in the market. Indeed, the market’s long-term average annual return hovers between 8-10%. This means that the money you invest will not generate higher returns than the debt you currently have.
Thus, you must rid yourself of all high-interest debts before you invest. Once they’re paid off, you can allocate those payments to stock market investments.
Exception: A mortgage or low interest debt – for example car payments – is not a major issue. If the interest is reasonable, you can pay them off in parallel to investing in the stock market.
- Build an emergency fund with 6-12 months living expenses
An emergency fund is a savings account whose money is earmarked for emergencies such as a car breakdown, a serious medical condition or a job loss. It’s important to have 6-12 months living expenses saved up so you don’t have to sell your investments to pay off these emergency expenses.
Do you know how to budget and save money? If you don’t, read Solaya Rabble’s Ultimate Guide to Budgeting.
- Prepare yourself psychologically
Long-term investing requires patience, discipline, and sacrifice. Indeed, building wealth by investing in the stock market can take decades.
Are you ready to sacrifice immediate gratification in order to have potentially greater future gratification?
If the answer is yes, then you are ready to invest. If the answer is no, then perhaps you should work on yourself before you commit to investing. Many people fall victim to the hyper-consumerist mindset and recklessly spend all of their money.
This means they don’t have the discipline to reduce their lifestyle and invest a fixed sum every month. Often, they will be tempted to sell their investments and spend the money, which will jeopardize their long-term financial objectives.
Before you invest, make sure you are comfortable with the idea of having less spending power every month. To help ease the pain of living “less large,” start small. Once you build the habit of saving, progressively increase the amount you’re investing. Lastly, visualize your financial objectives to motivate you.
2 – Having Unrealistic Expectations
Generating wealth takes a lot of time and patience. Many people enter the markets with the expectation of making a lot of money very quickly. Unfortunately, this is rarely the case.
- Have reasonable expectations
The S&P 500’s long-term average annual return is roughly 10%. Thus, it’s very unreasonable to expect yearly returns of 50% for the next 30 years. Every once in a while, you might make a shrewd investment that pays off big. However, understand that this is the exception rather than the norm. Be reasonable.
- Be patient
Do not invest money you will need within the next 5 years. While markets generally go up over the very long term, a bear market can occur at any time and last several years. Thus, your investments may need some time to become profitable. If you need to cash out your investments to pay off living expenses, you will set your yourself back and delay reaching your financial objectives.
3 – Trusting the Wrong People
New investors often place too much trust in analysts, anonymous posters on internet forums, and social media influencers. Anyone can recommend a stock, but very few people disclose their profit and loss track record. Also, even the best analyst can recommend a bad stock. Lastly, you never know an individual’s real intentions – be they good or bad.
One major problem facing investors is being flooded with social media gurus who promise you financial independence if you follow their strategies. Unfortunately, these gurus are usually using these promises to bait you into buying one of their very expensive courses. The sad truth is they’re making millions selling you thousand-dollar courses – not by investing thousands of dollars in the markets.
If something appears too good to be true, it usually is.
If you want to learn more about the financial markets, you should seek financial education from trusted sources.
4 – Buying Stocks and Financial Products You Don’t Understand
Many beginners buy stocks without knowing what the company does and buy financial products they don’t fully understand.
- Buying stocks of companies without knowing what they do
You know that Amazon is the global e-commerce leader. You buy the stock thinking that e-com is the main driver behind Amazon’s profits and stock price appreciation.
But did you know that e-com is one of the least profitable of Amazon’s revenue streams? As incredible as it may seem, e-com generates very little profits compared to the revenues it brings in.
In reality, Amazon Web Services (AWS), its cloud computing division, generates more profits than e-commerce despite bringing in less than half the revenue. That’s right, AWS is Amazon’s fastest-growing business segment and in coming years could bring in the majority of Amazon’s profits.
I chose this example to illustrate a very important concept: you must understand how a business operates before you buy its stock. While this appears to be a simple truism, very few beginners take the time to fully research a company before buying its stock.
5 – Too Much Trading
Many beginners trade too much.
They start off by buying the stock of companies they find interesting. However, they quickly sell once they identify other interesting companies whose stocks they think may rise much faster. Since they can’t buy every single stock they like, they buy and sell very frequently hoping to buy a stock that will multiply in value very quickly. Unfortunately, this is a very poor strategy. Here’s why:
You pay transaction fees on every buy and sell order you issue, which reduces your profitability. Commissions can even lead to negative profitability if you’re selling positions at break-even prices.
Unless your broker offers commission-free trading, abstain from buying and selling stocks too often.
- Capital gains taxes
Every time you sell a stock and make a profit, you owe the government a share of the gains. Many beginners forget this fact and get nasty surprises come tax time.
- Investments need time to grow
Very few investments “moon” overnight. Always remember that a stock represents ownership of a real company, and companies need time to grow and generate profits. Thus, it can take several years for an investment to pay off. If you sell the stock too quickly, you may regret it a few years down the line. If you identify a promising company, only buy the stock if you are willing to hold on to it for a long time.
- Long-term, the majority of traders lose money
Studies prove that the vast majority of traders lose money over the long term. While the exact percentage is up for debate, it’s undeniable that 80-90%+ of traders lose money after 5 years. Some studies even suggest that only 1% of traders are predictably profitable. The rest lose most of their capital. Don’t be one of them.
If you really want to trade, get education from trusted sources and be prepared to devote countless hours to perfecting your craft. Most profitable traders spend years – and thousands of dollars – developing winning strategies and forging the right mentality before they become profitable. The harsh truth is that the majority of people are not made to be traders.
If you quickly lose confidence in the stocks you are buying, ask yourself if you are doing the right amount of due diligence before investing. Most of the time, this is the real problem.
Lastly, make sure you understand the difference between investing and trading. They are two very different approaches – confusing the two can lead to subpar results.
6 – Buying Penny Stocks
A penny stock is a stock trading for less than $5 – and many trade for less than $1.
Many beginners like the idea of buying hundreds of cheap shares. After all, how hard can it be for a $0.5 stock to rise to $1 or $2?
Unfortunately, it’s actually very hard, if not impossible.
The simple fact is that penny stocks are cheap because they belong to unproven and usually very unprofitable companies. They are also very volatile and easily manipulated by scammers.
The classic manipulation tactic is called the pump and dump scheme.
First, the scammer will buy large quantities of an unknown stock. Then, he will promote the stock on forums and social media to attract investors. Generally, the scammer will claim that the company is on the verge of securing a lucrative contract, being bought out by a large firm, or developing a revolutionary product.
After much promotion, naive investors chasing a quick buck will rush to buy the stock and the price will start to increase rapidly. At this point, plenty of FOMO buyers – people who are scared of missing out on the gains – will start to buy in after a 100%+ price increase, hoping to ride the wave and make some easy money.
Once the scammer is satisfied with the price increase, he will start selling his shares below the market price. This causes the price to drop from its all-time highs, which wreaks total havoc. Seeing the price fall, investors will also start selling out of fear of losing all their capital. Those who sell quickly may make a small profit or break even, but those who are late to the party will be left holding a large number of worthless shares.
Stay away from penny stocks. Do not fall victim to a pump and dump scam.
7 – Not Diversifying
Many beginners invest all of their capital in just a few stocks. This is very dangerous because your portfolio’s profitability depends on the performance of those stocks. If they perform badly, your entire portfolio can be ravaged. That’s why it’s recommended to spread out your risk by buying 10-20 individual stocks.
Furthermore, you should diversify across sectors. If you only hold oil stocks and the price of crude plummets, your entire portfolio will be down. Also, oil companies may cut or eliminate their dividends.
Thus, you should seriously consider buying stocks from different economic sectors to avoid depending on a single sector for performance
8 – Not Buying Index Funds (ETFs)
It’s very difficult to consistently buy multi-bagger stocks. This requires intensive research, the ability to make the right call at the right time, and the courage to drop big money on highly speculative gambles. Additionally, it requires a large dose of luck. Most people rarely get lucky – and many don’t have the time or interest to spend hours trying to find the next Amazon.
Thus, for the majority of investors, the best option is buying a low-cost market-tracking index fund.
Read these articles for more information on index funds:
- Here’s Why You Need to Invest in Index Funds
- Time in the Market Beats Timing the Market
- 3 ETFs for Easy Dividend Investing
9 – Emotional Investing
Euphoria, greed, and fear are powerful emotions that often drive investment decisions.
When the market goes up, people rush to buy high-flying stocks because they fear missing out on the gains. When the market goes down, people panic-sell their falling stocks because they fear losing all of their money. Both of these strategies are short-sighted.
Always remember that volatility is inherent to the stock market so red days are perfectly normal. Also, remember that markets are resilient, and over the long term the S&P 500 goes up.
If the stocks you own go down, ask yourself why. Is it due to temporary bad news or to a structural decline in the asset’s fundamentals? If it’s the former, you should hold the asset; if it’s the latter, you should sell the asset.
Again, if you hold high quality assets, a drop in price is no reason to sell. Rather, it’s an opportunity to buy more at a discount.
The key lesson is to take emotions out of investing and to remain rational.
10 – Not Learning
The more you know, the less mistakes you will make. This is true in life and in investing as well.
Reading is one of the investor’s most powerful weapons. Luckily for us, the internet is a gold mine of readily accessible information. Leverage that information to your advantage.
To become a better investor, read books on the following topics:
- Great investors: How did the great investors succeed in the stock market? What lessons can we learn from them?
- Business: Learn about business. What makes a great business? How do businesses fail and succeed?
- Management: Businesses need great management to succeed. Learn about great leaders to identify companies with innovative leadership.
- Economics: How does the economy work? How do political decisions influence the stock market? Which countries are growing and poised to capture the future growth of the global economy? Which ones are in decline?
- Monetary policy: What is money? How is it created? How does the increase or decrease of the money supply affect the economy and the stock market?
- Industries and sectors: What is the weight of a given industry in your country or the world’s economy? Which sectors are poised for future growth? Which ones are in structural decline? Who are the market leaders and emerging actors?
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DISCLAIMER: This article is the fruit of my personal research and should not be viewed as financial advice. I enjoy analyzing stocks and providing investment ideas but I highly encourage you to conduct your own research before investing in any asset. NEVER invest without having done proper due diligence and NEVER invest out of the Fear Of Missing Out (FOMO). Also, NEVER invest because some internet message boards are hyping up a high-flying stock. As a rule of thumb, the number of rockets included in a tweet are inversely proportional to the quality of the advice given.