Six Dangerous Moves for First Time Investors
Thanks to online discount brokerages, anyone with an Internet connection and a bank account can be up and trading stocks within a week. This ease of access is great because it encourages more people to explore investing for themselves, rather than depending solely on mutual funds or money managers. However, there are some common mistakes that first time investors have to be aware of before they try picking stocks like Buffett or shorting like Soros.
1) Jumping in Head First
The basics of investing are quite simple in theory – buy low and sell high. In practice, however, you have to know what “low” and “high” really mean. What is “high” to the seller is considered “low” (enough) to the buyer in any transaction, so you can see how different conclusions can be drawn from the same information. Because of the relative nature of the market, it is important to study up a bit before jumping in. At the very least, know the basic metrics such as book value, dividend yield, price-earnings ratio (P/E) and so on. Understand how they are calculated, where their major weaknesses lie, and where these metrics have generally been for a stock and its industry over time.
While you are learning, it’s always good to start out by using virtual money in a stock simulator. Most likely, you'll find that the market is much more complex than a few ratios can express, but learning those and testing them on a demo account can help lead you to the next level of study.
2) Playing Penny Stocks and Fads
At first glance, penny stocks seem like a great idea. With as little as $100, you can get a lot more shares in a penny stock than a blue chip that might cost $50 a share. And, you have a lot more upside if a penny stock goes up by a dollar!
Unfortunately, what penny stocks offer in position size and potential profitability has to measure against the volatility that they face. Penny stocks are penny stocks for a reason – they are poor quality companies that, more often than not, will not work out profitability. And, losing $.50 on a penny stock could mean a 100% loss. Penny stocks are exceptionally vulnerable to manipulation and illiquidity. Getting solid information on penny stocks can also be difficult, making them a poor choice for an investor who is still learning.
Overall, remember to think about stocks in percentages and not whole dollar amounts. And remember, you’d probably prefer to own a quality stock for a long time than trying to make a quick buck on a low-quality company (except for professionals, most of the returns on penny stocks can be drilled down to luck).
3) Going All In With One Investment
Investing 100% of your capital in a specific investment is usually not a good move (even 100% in a specific commodity futures, forex or bonds). Any company, even the best ones, can have issues and see their stocks decline dramatically. You have a lot more upside by deciding to throw diversification to the wind, but you also have a lot more risk. Especially as a first-time investor, it’s good to buy at least a handful of stocks. This way, the lessons learned along the way are less costly, but still valuable.
4) Leveraging Up
Leveraging your money by using a margin means that you borrow money to buy more stock than your own money by itself can afford. Using leverage magnifies both the gains and the losses on a given investment.
Take this example – you have $100 and borrow $50 to buy $150 of a stock. If the stock rises 10%, you make $15, or a 15% return on your capital. But, if the stock declines 10%, you lose $15, or a 15% loss. More importantly, if the stock goes up by 50%, you make 75% return. But, if the stock declines 50%, you lose all your money!
There are other forms of leverage besides borrowing money, such as options, which can have a limited downside or can be controlled by using specific market orders, as in forex. But, these can be complex instruments that you should only use once you have a full grasp of the market. Learning to control the amount of capital at risk comes with practice, and until an investor learns that control, leverage is best taken in small doses (if at all).