Earlier this week, I shared 3 tips for how to choose stocks. Knowing what not to do, however, can be equally important. Steer clear of these five common investing mistakes when building your portfolio:
Thinking any investment is a sure thing.
While markets generally trend upward, strange things can and do happen. Case in point: even the seemingly untouchable housing market came crashing down. And while Michael Burry predicted the crisis, few others did or could have. Other instances are entirely unforeseeable from the outside. Enron, once a golden child of stock picks, fell from grace suddenly when scandal knocked stock prices from their $91 peak to less than $1 per share in only about a year’s time.
In the end, no matter how confident you are in a stock pick, random circumstances beyond your control can influence a company or even an industry as a whole. And while preventing or anticipating these developments is often near impossible, it’s important to be aware of uncertainty and prepare accordingly.
Building a diversified portfolio can help prevent a single, unexpected event from crippling you financially, and helps shield you from potential volatility. So resist the temptation to commit your life savings to one single investment or even industry, regardless of how “safe” or “sure” it may seem. Ideally, when the price of one stock slumps in a diversified portfolio, another may rise, offsetting losses and thus minimizing risk. No investment is a guarantee, so diversification can prevent against putting all your eggs in one basket.
Paying too much attention to short-term noise.
Despite a myriad of small blips and a few considerable recessions, markets tend to move up and to the right over time — it’s what makes investing such a prominent vehicle for building wealth. But dips do occur. While the stock market may experience periods of sustained growth and sizable returns, it can also be volatile and irrational. Stock prices rarely (or never) move linearly, so downturns both large and small are bound to happen. But that doesn’t mean they’ll last forever. In fact, in a majority of cases, the market fully recovers its value within about 10 months. For buy-and-hold investors, that time frame is likely a drop in the bucket.
So keep your cool and resist the urge to make rash decisions. The same goes for individual stocks, too.
Entire publications dedicate their pages to reporting on company news and market shifts that have the potential to influence stock prices. It seems that each day, a new “earth shattering” announcement (or seven) breaks, sparking fear or hope among investors and potential investors. Meanwhile, events that truly influence a business or industry in the long run occur much less frequently. The key is to differentiate between mere fodder and news that truly affects your story. Will you remember in 3 years that this took place? In other words, is it impactful in the big picture? These questions will help you distinguish between what matters and what doesn’t so you can follow the trend lines, not the headlines.
Blindly taking advice without doing your own research.
In my earlier post this week about how to choose stocks, I detailed the importance of doing your research. That means uncovering insights to develop your own opinions around a company — not surfing the web to find other investors’ opinions or asking your neighbor who happens to be an investment advisor. Not that you can’t do those things, you’ll simply want to do a bit of digging on your own to ensure the price and value align with your personal expectations, risk tolerance, timeline and financial goals. What works for one person may not be right for another.
While it’s fine (and often helpful) to examine what the pros are doing as you begin your research, be sure to form your own opinions based on the information available to you. In the end, your decision to buy shouldn’t boil down to, “because Warren Buffet said so.” It’s OK to come to the same conclusion, but be sure to do so on your own terms — don’t use advice from others to cut corners in your analysis.
Not putting metrics in context.
OK, so you’ve done your due diligence by researching your industry or company of choice. Don’t invalidate all your hard work now by neglecting to put the data you’ve uncovered into context.
In my previous post, I explained basic metrics for stock valuation, such as the price-to-earnings (P/E) ratio. And while the P/E ratio serves as a valuable yardstick, it’s important to factor other inputs into consideration, rather than taking P/E at face value. While a low P/E may indicate a company is undervalued, investors shouldn’t automatically discount companies with higher P/E ratios. A larger P/E could indicate potential for greater earnings growth in the future. Even two companies with identical P/E may differ dramatically if one is growing while the other is shrinking.
The point is, data doesn’t exist in a vacuum. Acting as though it does constitutes one of the most common investing mistakes. For example, if revenue recently skyrocketed, evaluate the context. Was the increase fueled by savvy business decisions? Or does it appear to be the result of an extraneous event that likely won’t result in lasting, long-term growth? Be sure to include a variety of quantitative and qualitative measures in your assessment of stock value and price to get the full picture before investing.
Giving in to the hype.
Not all trends are worth the hype. Just because everyone wore bell bottom jeans doesn’t mean they looked good on you. The same goes for many investing frenzies — just because everyone seems to be snapping up shares left and right doesn’t mean growth is sustainable (or well-founded). And just because someone else saw returns in the past, doesn’t mean you’ll see returns in the future. These frenzies often precede speculative bubbles, and once you hear about a trendy stock in the media, it’s often reaching (or already reached) its peak. In other words, you’ll likely buy high just as prices begin to decline.
Take the cryptocurrency craze, for example. Do we know for sure at this point that Bitcoin is an asset bubble? Not necessarily. But you invested during the height of the Bitcoin the hullabaloo when it reached its peak in mid-December 2017, you would have lost nearly two-thirds of your investment by early February. Translation: don’t invest because of FOMO. Take time to do the research (are you sensing a trend here?) and form your own opinion on whether real value exists. It’s like your mom used to say: “If all your friends jumped off a bridge, would you jump, too?”
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