Stock investing can be fun and exciting but when it is not executed properly, the experience can be financially and emotionally disastrous.
It is easy to make money in the stock market if you know how to play the game. Many hopeful beginners try to invest in stocks, expecting to make quick trading gains, only to lose their hard-earned savings after a few months.
There is always the risk of losing money when you invest in the stock market because share prices fluctuate daily without certain direction. Your task as an investor is to manage this risk and control the behavior of the market in your favor.
While it is common to make mistakes when making investment decisions, you can minimize the risks if you know what you are doing. Here are the five pitfalls every new investor must avoid when investing in the stock market:
1. Buying on rumors and tips
When you hear tips from your friends or stockbroker to buy certain stocks because they heard it from a reliable source, you tend to use more of your emotions rather than logic in making investment decisions.
Sometimes it is difficult to make decisions based solely on emotion, especially when you see everyone chasing the same stock.
It is not easy to simply listen to your gut, or follow your heart, when you could not possibly know what the stock price will be worth a few months or years from now without knowing the fundamentals.
By experience, the market reacts on rumors easily, making the stock price go up quickly. But once the news is proven false, the stock can simply reverse and plunge even lower.
There is nothing wrong with listening to rumors, but always verify it with the fundamentals of the stock. One way to do this is by reviewing the past disclosures of the company and try to relate the rumor with facts to determine if there is any basis.
If you find any connection with facts and rumors, assess the implications on the company and how this will probably affect the stock price in the future.
2. Buying on stockbroker’s recommendations
A number of stockbrokers in the market keep a team of research analysts who follow companies and make recommendations for their clients. Your stockbroker may be sending you regular research reports on what stocks to buy or sell.
Sometimes, they provide target prices as a guide. This is actually good information as the research has already been done by other people for you, but you should not rely on their recommendation blindly.
You have to remember that what your stockbroker is suggesting to you is their opinion. Other brokers may or may not agree with what they are recommending. You may also have a different opinion based on what you know.
While it is good to get research reports from brokers, you can use this to support and evaluate your investment decision. When you read research reports, always verify the assumptions made before making a decision.
3. Buying to make small quick profits
The idea of buying and selling stocks on the same day for profit is very tempting, especially if the market is highly volatile.
The good thing about succeeding in day trading is that you are not obligated to pay your broker on settlement date because you sold the same buying position on the same day. Because you made a profit, it will be your broker who will hand you the check.
This is nice but this doesn’t happen every day. Unless you are a professional trader, investing in the stock market with the aim to make small money by day trading regularly can be highly risky. In fact, the risks can be likened to gambling in the casino.
Trading for short-term gains on a regular basis will likely cause you to lose more than you can imagine because the more you trade, the more transaction costs you are going to incur.
This is not to mention the losses that you need to absorb when you make the wrong bet. While it is true that you may make some money in some good trades, your cumulative trading costs will ultimately offset all your gains and possibly more.
4. Buying by borrowing money to invest
Make sure that the money you invest in the stock market is the money that you can afford to lose. Do not use your lifetime savings that you intend to use in, for example, paying for your brother’s tuition fee next year or the airfare for your family travel this Christmas.
When you trade on a margin facility provided to you by your stockbroker, you are essentially borrowing money. For example, the stocks you bought and paid for has a market value of Php10,000. If you trade on margin, you can borrow up to Php10,000 or more to buy the same stock without cash out from your side.
Imagine for every 10-percent increase in stock price, your return on investment will be 20 percent. This is great if the stock price is going up because you can leverage on borrowed money, but if the stock price goes down, your losses will also double.
Your main risk is if your stock plummets by 50 percent, you would have wiped out all your capital and possibly more if the fall continues. Use margin facility only if you know how to discipline your trading and manage your risks.
5. Buying without knowing the company behind the stock
When you buy a stock, treat it as if you were buying the company. Try to understand what kind of business the company is into and assess its business model.
How does the company make money? Does the company possess the capacity to sustain its earnings and cash flows? Do you trust the people behind the company? How familiar are you with the company’s products and services? If the company is too complicated for you to understand, look for another stock with a simpler business model.
When you understand the fundamentals of the stock, you will know how the company makes it earnings. Stock prices are valued based on expected earnings. The better the earnings outlook of the stock, the higher the expected valuation of the share price in the future.
Henry Ong, RFP, is president of Business Sense Financial Advisors. Email Henry for business advice firstname.lastname@example.org or follow him on Twitter @henryong888