19 Mistakes To Avoid When Investing In The Stock Market
Updated on May 7th, 2020
Here’s a frank discussion.
The average person isn’t an “investing type” of person and will encounter too many ways to lose money in the stock market. They would be better served by sticking to a robo-advisor, a lifecycle fund, or simply an index fund like the Total World Stock Market Index (VT) and call it a day.
Many employers offer free services with financial advisors through their 401(k) plans and they should consult with them as well. These options are about the closest things you can get to a “sure thing” in investing, if you have a long enough time frame.
For my more experienced readers, whom most of my articles apply to, this isn’t news, but I have gotten some feedback from some less experienced investors that they don’t understand some of the topics I have written about like MLPs and preferred share investing, so I wanted to point out the path they should strongly consider.
Investing is work
Investing properly takes effort. It requires lots of reading, not only on investing books to get ideas on what works and what doesn’t, but also prospectuses, corporate material, and investing theses by others. Basically you want to have a well rounded viewpoint and that’s just for a single company! The problem is, it is a big time commitment.
Most people are raising a family, have a full time job, spend an hour in the car on their commute each day, go to the gym, walk their dog, and spend time with their friends for social activities. Spending a Saturday night digging through financial statements is reserved for a special class of nerd like me.
Some want to take a short cut to big riches and fall victim to common investing traps:
Ways to Lose Money in the Stock Market
- Buying a stock because a friend of a friend who “knows something.” This friend of a friend likely doesn’t know anything more than the general public does because if they did it would be illegal insider trading.
- Assuming that someone else knows something because the stock sells off or runs up right before an earnings report. I can’t tell you how many times I have seen it reverse right after the earnings report!
- Reading a Robo-generated article like Zacks Investment Research and then buying based on what it said.
- Signing up for a stock picking newsletter and buying its picks blindly.
- Was negative information suppressed?
- Is the newsletter just another a paid stock promoter (most seem to be) that is going to pump it and then dump it?
- Betting the farm on a small number of ideas, or in other words not diversifying.
- Almost all of the greatest investors in the world have made their fortune by having concentrated investments, but ask yourself if you are likely to be one of these guys? If you’ve had great tremendous investing success in the past, then by all means go for it, but be honest with yourself.
- Related to number 5 is betting large sums of money on fads.
- I’ve known people who bet their entire account balances on things like Bitcoin, Tesla and marijuana stocks. It may work out for a while, but usually when you hear of the fad, it’s already on its last leg.
- Related to #6, buying because of a story from a press release, such as a COVID-19 vaccine or a drug that a Biotech is working on.
- Usually by the time you’ve read the press release the stock has already peaked and others will start to take profits and shorting it down.
- Often these new developments are pretty flimsy in that it will take a long time for the company to develop their product and to make money from it, if ever. Sometimes it is a ploy to puff up the stock valuation just before a secondary offering.
- Using too much leverage.
- This can be done with options or borrowing funds. With Regulation T, your brokerage will allow you to buy 2 times the money you contribute to your account (and much more with portfolio margin).
- Leverage cuts both ways and works great when the market is going up but can wipe you out on a strong downward movement.
- You can actually lose more than you put in, if your brokerage doesn’t stop you out in time or there is a large gap-down overnight.
- Also, with the typical brokerage charging around 8% on borrowed funds, the odds aren’t great that you will exceed that hurdle and actually make money.
- Using options incorrectly. Such as
- Buying far out-of-the-money call options with a low probability of paying off (lotto tickets).
- Doing strategies the gurus promote as easy money like Covered Calls.
- Buying penny stocks: Grand promises, not much of an actual company underneath to execute upon.
- Psychological investor biases such as holding on to losers too long and selling winners too soon. Those are known as loss aversion and disposition effect, respectively. This is basically what Covered Calls emulate.
- Being too emotional. When the market drops like it did in 2018 and 2020, do you panic and sell, locking in losses, or do you take the opportunity to re-balance?
- Catching falling knives. A stock that suddenly drops tremendously looks like a sale, but trying to pick the bottom before it has settled down is what gave the term its moniker.
- Ignoring fees. In Oct 2019 all major brokers removed commissions so trading stocks has become cheaper than ever, but don’t ignore fees on mutual funds or exchange traded products.
- There are still plenty of mutual funds and CEFs out there that charge 1-3%. I have no idea how they still exist because most of them don’t outperform. My only suspicion is that asset owners haven’t paid much attention to the funds they own for a while, or don’t want to move to incur long-term capital gains taxes. They should run some numbers on whether that tax avoidance is worth it.
- Only using ratios reported on a stock summary page and investing based on that information.
- “Its P/E is greater than 30, so its too expensive to buy”
- “Its P/E is lower than 10, so it must be a great buy”
- Trusting adjusted or non-GAAP earnings numbers of press releases.
- These can be fluffed. Charlie Munger of Berkshire Hathaway calls them bullshit.
- Blindly trusting the GAAP numbers in press releases, see point #15.
- Not understanding the company’s product.
- What markets does it serve?
- Are there enough customers or is it a niche product?
- Saving best for last, not examining 10-Q/K’s for a company you are investing in. There are a lot of nuances in financial statements that differs from industry to industry and firm to firm.
- Earnings can increase from year to year but did they do that with organic revenue generation or did they cut costs? Did receivables jump considerably from period to period?
- How does the balance sheet look? Are they using lots of flimsy intangibles to puff up the valuation of their asset base?
There are more ways to lose money in the stock market for sure, these were just the ideas that stood out to me as I was writing this article.
Know Your Limitations
It’s fun for people to pick stocks with a little play money and that is fine. Losses up to $3,000 are tax deductible.
Just know what you are up against if you haven’t had a lot of experience investing in stocks before. It’s not easy. It takes time. It takes effort.
You should always have a your own good reasons for buying a stock. Even with a good investment thesis, things change or the thesis doesn’t always pan out, but at least when you entered the position you had a thought out reason to buy.
It is completely okay to take the easy way out and stick to index funds. You’ll do fine if you do so and you’ll have less to worry about. And there’s nothing wrong with that.
Continue reading about a risk free 20% return on your rent or property taxes.
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