Why New Investors Fail
When anyone gets started with investing the first thought is usually about getting rich quick and never having to worry about money again. It's a wonderful thought, I continue to have it quite regularly. But that's rarely (so rare you could lean towards saying never) the reality.
I believe the most common and consequential mistakes new investors make are psychological and therefore avoidable but only if you understand them. The ability to observe, understand and avoid making some of these mistakes can make a huge difference in your ability to invest efficiently. Being a successful investor relies heavily on your ability to avoid 'traps', think rationally and not to let one good investment blow up your ego.
Let's take a look at some of the most common mistakes that are made, based on my own experiences and from what I've read.
Fear of Missing Out (FOMO) - it's easy to hear about all of these new 'hot stocks' people are making a lot of money from and feel like you're missing out on the riches. My advice is to approach these situations with skepticism. As was told in A Random Walk Down Wall Street (my review here), there have been a lot of hot stock bubbles that were overpriced and collapsed with many people losing a lot of money. By the time someone is telling you about a hot new trend, it may already be too late.
Outside influences - most people get started with investing by word of mouth. Investing is a smart thing to get into, but I would be careful about getting recommended which stocks to buy without doing your own research. Just like with FOMO, you shouldn't jump on a bandwagon unless you know where it's going and who's pulling it. It's always a great idea to know as much as you can about a company before buying it.
Warren Buffett suggests buying a stock that you would be comfortable owning if the market closed tomorrow, would you be comfortable if your money was untouchable based on someones lucky feeling?
Being irrational - no one will ever know the best point to buy and sell stocks, it can't be forecasted accurately, just speculated on. This is why it's important to act rationally and know what your ideal prices to buy and sell are. It's easy to get caught up in the moment. When a stock is falling it's easy to say 'it's going to turn around any second now!' and you watch it and keep saying that for hours, days, weeks and then you're shaking your head because you should have sold ages ago. And on the flip side, you see your stock price rise quickly and think it's unstoppable, then it starts to drop and you say it's only a small dip and then before you know it the price is back to where you bought it at. Don't be afraid to cut your losses early and take profits when they are available. One of my ten rules is 'Small Gains = Big Profits'.
Expectations - chances are you're not going to become an overnight millionaire and that's okay, it's how it's supposed to be (sorry). You're most likely not going to end up quitting your job to become a day trader. Keep in mind that investing is over the long term and keep in mind what typically returns have been. If you keep your expectations in check you're going to be able to look at things rationally and say 'the S&P 500 has averaged 9.5% over the past 90 years, I've made 10% on this investment, I should take my profit and reinvest it in something safer and less risky'.
Valuing price - bare with me on this one. Let's take a look at a fictitious scenario... Company A has a share price of $100/share and Company B has a share price of $10,000/share. Most peoples initial instinct is that $10,000 is expensive for one share. Let's introduce Company C trading at $5,000/share. So far all we really know is a price for a single share. These companies could all be very different in nature and not comparable at all.
Say these three companies were in the transportation industry. Company A sells a bike for $100, Company B sells a car for $10,000 and Company C sells a bike for $5,000. Now that we know more about these companies it's easy to say that Company A is the cheapest option, Company C seems very expensive (for what a bike should cost). Company B isn't very comparable because it's not a bike, but I think a lot of people would say a car is more practical, useful and valuable to the average person than a bike (I am pro-bike by the way).
Just because a stock is inexpensive or cheap doesn't make it a reason to buy, in fact if a stock is very cheap it's probably a good reason not to buy it. Comparing different stocks based on their current stock price doesn't make sense. Comparing the current stock price to a stock price based on the valuation of the company will give you an indication if it is a good time to buy or not (value investing).
Eggs all in one basket - your neighbour told you he's going to make a million dollars from this hot new sector and to maximize his profits invested all of his money in this industry in a select few stocks. Good idea? Definitely not, but you could say maybe not; to be polite. Most sources would suggest using a small amount (~10%) of your overall portfolio on high risk speculative stocks, and have the rest of it in diversified stocks, bonds and cash.
From what I've experienced is emerging industries usually tend to move more or less in unison. Yes there are slight differences from company specific information or performance but most of the time green or red days are consistent throughout the board. Instead of investing in a handful of companies it could make sense to invest instead in an ETF or index fund for that industry. If there's 100 new companies in an emerging market the probability of you picking the top few only are slim, whereas ETF's of index funds can be made up of dozens of these companies.
Rebalancing portfolio - a rule of thumb is your age should be your portfolio allocation for bonds (age 25 = 25% invested in bonds). It is important to try to maintain this rule over the years in order to protect your investments. Hopefully your stocks are performing very well so your percentage allocated to stocks grows and grows, try to rebalance once a year. It's also a good time to check overall performance and make sure your investment strategy is going according to plan. It doesn't have to take up a lot of your time, but it's something worth knowing.
How can you try to avoid these mistakes?
The best thing to do in order to avoid making these mistakes is actually quite straight forward, have a plan. It isn't as simple as it sounds though. Having a plan would be like phase one, the hard part is phase two: being committed to the plan. It's happened to me many times, where I have my plan, I know what I should do, but instead I deviate from the plan and make a mistake. So here's what I suggest to do to prepare for investing, ideally before you start investing:
Know why you are investing - what are your goals, what are you trying to achieve?
Understand your timeline - good things take time and that's no exception with investing. Invest for the long term and don't worry about small hiccups here or there.
Know what you're investing in - buy stocks of companies you like and understand. If you love a company and see it having a bright future it could be a good starting point.
Do your research - maybe you're not an investing expert, but you don't have to be to make decisions for yourself. Research companies before you invest in them.
Stay committed to your plan - this is the toughest one, stay committed. If you know someone who also invests I would suggest forming a partnership of sorts. Hold each other accountable to your plans, if you deviate from your plan let them know and talk about it. If you're thinking of deviating from your plan, discussing your reasons will either strengthen your idea or make you reconsider it.
It's easy to make mistakes when it comes to investing, I know first hand and I'm not going to lead you to believe otherwise. Once you know and understand what the more common mistakes are, it's easier to identify them when they appear to you. Understanding how to approach them and having an idea of how to avoid making a big mistake is important. At the same time, you will make mistakes, everyone does. But don't let it give you the impression that you suck at investing or should give up, like anything else it's a learning process.
If you have any tips you'd like to share about investing mistakes you've seen or that you think should have been included in this list leave a comment and let me know. Or if you have any advice on how to avoid them. I think the best way people can benefit from this blog is if we have a variety of experiences and advice, so don't be afraid to speak up.
Usually you don't have to ask someone twice for them to tell you all about their huge payoffs. People love to brag about their success stories. In the next article I'm going to tell you my three biggest mistakes, and it was a tough time narrowing it down to three. But my three biggest mistakes I think are things every new investor faces. Hopefully by learning about mine you can avoid them and be a better investor because of it.