"You get recessions, you have stock market declines. If you don't understand that's going to happen, then you're not ready, you won't do well in the markets." -- Peter Lynch
Peter Lynch, famous for leading Fidelity Investment's Magellan mutual fund for 13 years, during which he averaged annual gains of about 30%, is right. You need to have a solid understanding of the stock market in order to profit from it -- and to know the key mistakes to avoid.
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Here are six common blunders that investors make that can cause them to lose much, if not all, of their money. (In some cases they may even lose more than they invested!)
1. Timing the market
If you're spending time wondering if this is the right time to start investing in stocks or the right time to sell your stocks, you're engaging in market timing. That's when an investor gets in and out of the market based on whether they think it's heading up or down.
Some investing gurus will suggest that they know where the market is headed in the near future, but don't believe them. Researchers at Morningstar.com found that over the 20 years between 1992 and the end of 2011, the market averaged 7.8% annually. If you were out of the market on the 10 worst days in that period, you'd have averaged 12%, while if you were out during the 10 best days, you'd have averaged 4.1%. That might look as if it demonstrates the value of market timing, but identifying the best or worst days in advance is easier said than done. As index-fund pioneer John Bogle has quipped, "Sure, it'd be great to get out of stocks at the high and jump back in at the low, [but] in 55 years in the business, I not only have never met anybody who knew how to do it, I've never met anybody who had met anybody who knew how to do it."
2. Frequent trading (a.k.a. day trading)
Trading frequently -- such as when one day trades -- can be another wealth-shrinking move. According to an academic study of frequent traders by Brad Barber and Terrance Odean, between 1992 and 2006, fully 80% of active traders lost money and "only 1% of them could be called predictably profitable." Even the Securities and Exchange Commission (SEC) has warned against day trading, saying such things as: "Be prepared to suffer severe financial losses. Day traders typically suffer severe financial losses in their first months of trading, and many never graduate to profit-making status."
Part of the problem with frequent trading is that you can rack up hefty commission costs. If you trade 10 times per day and pay a seemingly reasonable $10 fee each time, over the course of about 250 trading days during the year, you'll pay $25,000 in fees! And whenever you realize a gain, you'll pay a steep tax rate. The capital gains tax rate on short-term investments (those held a year or less) is the same as your income tax rate, which is 25% for most of us and 28% and higher for higher earners. On long-term capital gains, though (from assets held for more than a year), most of us will face a tax hit of just 15%. The following table shows how meaningful these differences can be:
3. Investing on margin
Beware, too, of investing with borrowed money -- i.e., using "margin." Buying stocks "on margin" is perfectly legal and it can greatly amplify your gains -- but it can amplify your losses, too. For starters, brokerages charge you interest to use margin. At one major brokerage, for example, the recent rates ranged from 6.75% if you borrowed a million dollars or more to 9.5% if you borrowed less than $10,000.
Here's one reason margin is problematic: The equity in your account is the collateral that you're putting up for the loan. If the value of your investments made on margin start falling significantly, you'll get a "margin call" from your broker, asking you to sell some assets to generate cash, or to deposit more cash into your account. If you fail to do so, the brokerage may just sell some of your holdings for you. If you invest on margin, you can lose more than you invested. If you borrow a lot for a long period, you'll rack up significant interest expenses, too.
4. Following your emotions
Another common stock market error is making investment decisions based on emotions such as fear or greed. If the stock market crashes and many people sell stocks in a panic, causing stock prices to fall further, it will be tempting to join them, but think twice about that. Doing so will mean locking in a loss or a smaller gain, while parking yourself on the sidelines for the eventual recovery. Whenever there's a downturn in one or more of your holdings, do some digging before selling. Find out if there's a lasting problem or just a temporary one. Ride the temporary ones out.
Meanwhile, if you're drooling over some high-flying stocks, know that they're flying high because many people are excited about them and snapping up shares, sending the share price up. That's when greed can have you jumping on the bandwagon, too -- no matter whether the stock is actually overvalued now or undervalued.
It's best to follow the advice of superinvestor Warren Buffett, who said, "Be fearful when others are greedy, and greedy when others are fearful."
5. Penny stocks
A classic rookie mistake in the stock market is investing in penny stocks -- stocks that trade for less than about $5 per share and are usually tied to unproven, volatile companies. They're often easily manipulated because of their having relatively few shares outstanding.
You can steer clear of penny stocks by avoiding companies with very low share prices -- no matter how you love the idea of being able to own, say, 2,000 shares of a company for only a $500 investment. Remember that a $0.25 stock can still plunge and become a $0.05 one. And a $200 stock can always grow into a $400 one. Don't read too much into a stock price.
6. Shorting stocks
Think twice before "shorting" stocks, too -- where you're betting against them. It's legal and possible to profit from it, but there will be forces working against you.
The typical way to invest is to establish a "long" position in a stock, where you buy shares and hold them, expecting them to increase in value. You plan to sell the shares later at a profit. Shorting, though, reverses that. Instead of buying low and selling high, shorting involves aiming to first sell high and then buy low. Imagine, for example, that you think shares of TypewriterMart (Ticker: QWERTY) are very overvalued and likely to fall in value. To short the stock, you would have your broker borrow some shares from someone else's account and then sell them. The idea is that later, when the shares have fallen, you can buy them on the open market for less and replace them. If they fall as expected, then you'll profit, as you hoped to. But stocks don't always behave as expected. If you're long a stock and it falls from $50 per share to $0, you can lose all your money. If you're short a $50 stock, though, and it triples in value, you will be having to replace the borrowed shares at some point, and will have to pay much more than the $50 you pocketed when you shorted it. When you're long a stock, your downside is capped at 100% and your upside is theoretically unlimited. When you short a stock, it's the reverse. Remember, too, that while you bet against a company, you'll have its management working against your interests, trying to increase its value.
Some of the stock market investing approaches above may tempt you at one time or another, but always remember: You don't have to take such risks. You can do very well in the stock market just by buying into and holding for the long term stock in healthy and growing companies.
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