Fact checked by Vikki Velasquez
First-time investors should be aware of some common mistakes before they try their hand at picking stocks like Warren Buffett or shorting like George Soros. The basics of investing are quite simple in theory: Buy low and sell high. You have to know what “low” and “high” really mean in practice, however.
Key Takeaways
- Investing can be an exciting way to grow your wealth and secure your financial future.
- First-time investors tend to repeat similar mistakes that can undermine their success.
- Investing emotionally, chasing fads, loading up on penny stocks, and failing to diversify are all potential missteps.
- It’s best to begin small when you’re starting to invest and take the risks with money you’re prepared to lose.
Jumping in Head First
What’s “high” to the seller is considered “low” or “low enough” to the buyer in any transaction. Different conclusions can be drawn from the same information. It’s important to know the relative nature of the market before jumping in.
The basic metrics such as book value, dividend yield, and price-earnings ratio (P/E) are fundamental items to learn. Understanding how they’re calculated, where their major weaknesses lie, and where these metrics have generally been for a stock and its industry over time can help a new investor immensely.
It’s always good to begin by using virtual money in a stock simulator. You’ll most likely find that the market is much more complex than a few ratios can express. Learning and testing them on a demo account can help lead you to the next level of study, however.
Playing Penny Stocks and Fads
Penny stocks seem like a great idea at first glance. You can get a lot more shares with as little as $100 in a penny stock than a blue chip that might cost you $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 be measured against the volatility they face. Penny stocks are penny stocks for a reason. They’re poor quality companies that won’t work out profitability more often than not. Losing even $0.50 on a penny stock could mean a 100% loss.
Important
Penny stocks are exceptionally vulnerable to manipulation and illiquidity.
Think about stocks in percentages and not whole dollar amounts. You’d probably prefer to own a quality stock for a long time than try to make a quick buck on a low-quality company. Most of the returns on penny stocks can be drilled down to luck except for professionals.
Going All in With One Investment
Investing 100% of your capital in a specific investment isn’t usually a good move, even if it’s 100% in specific commodity futures, forex, or bonds. Even the best companies can have issues and their stocks can decline dramatically.
Investors have a lot more upside by throwing diversification to the wind but this also carries a lot more risk. It’s good to buy at least a handful of stocks, especially if you’re a first-time investor. The lessons learned this way are less costly but still valuable. Exchange-traded funds (ETFs) are a great way to get broad exposure.
Leveraging Up
Leveraging your money by using a margin means borrowing money to buy more stock than you can afford. Using leverage magnifies both the gains and the losses on a given investment.
Assume you have $100 and you borrow $50 to buy $150 of stock. You make $15 or a 15% return on your capital if the stock rises 10%. You lose $15 or suffer a 15% loss, however, if the stock declines 10%. You make a 75% return if the stock goes up by 50% but you lose all the money you borrowed plus some if the stock declines 50%.
There are other forms of leverage other than borrowing money such as options. Some can have a limited downside or can be controlled by using specific market orders. These can be complex instruments that you should only use after you have a full grasp of the market, however.
Learning to control the amount of capital at risk comes with practice. Leverage is best taken in small doses if at all until an investor learns that control.
Investing Cash You Can’t Afford to Lose
Studies have shown that cash put into the market in bulk rather than incrementally has a better overall return. This doesn’t mean you should invest your whole nest egg at once, however. Investing is a long-term business whether you’re a buy-and-hold investor or a trader. Staying in business requires having cash on the sidelines for both emergencies and opportunities.
You’re not in a financial position where investing makes sense if you have only enough cash to invest or to have an emergency cash reserve. This kind of investing leads to making mistakes due to behavioral biases.
Chasing News
Investing in news is a terrible move for first-time investors whether they’re trying to guess what the next “Apple” will be, investing quickly in a “hot” stock tip, or going all-in on a rumor of earth-shaking earnings. Investors are competing with professional firms that not only get information the second it becomes available but also know how to properly analyze and act on that knowledge and not fall for an investing fallacy.
What Is a Penny Stock?
The U.S. Securities and Exchange Commission (SEC) puts a number on it: They’re stocks that trade for under $5 per share. These companies typically aren’t listed on the major stock exchanges. They’re unproven, often troubled, and their stocks tend to be highly volatile, thus their low prices.
What Is a Buy-and-Hold Investor?
A buy-and-hold investor tends to be passive. They’re in it for the long haul as the name suggests. They trade on the theory that equities provide a higher return and can ride out times of volatility and market fluctuations when they’re held across long time horizons. The strategy is also referred to as position trading. The approach has its fans, Warren Buffett among them.
What Is a Good First Investment?
Ideal first investments include companies you understand and have personal experience dealing with. You wouldn’t keep betting on black at a casino to make long-term profits so you shouldn’t do the investing equivalent of this.
The Bottom Line
First-time investors often fall prey to the same errors and making mistakes can cost a good bit of money over time if their mistakes aren’t addressed and rectified. Some of the most common mistakes include a lack of diversification and following their hearts rather than their minds. Consider opening a demo account and practicing before you jump in with both feet. Study and gather guidance from reputable sources.
Disclosure: Investopedia does not provide investment advice. Investors should consider their risk tolerance and investment objectives before making investment decisions.