Anybody, no matter what his or her educational background, IQ, occupation, income, or assets, can make solid returns investing in stocks. To maximize your chances of stock market investment success, remember the following:
1) Don't try to time the markets
Anticipating where the stock market and specific stocks are heading is next to impossible, especially over the short term. Economic factors, which are influenced by thousands of elements as well as human emotions, determine stock market prices. Be a regular buyer of stocks with new savings. As I discuss earlier in this chapter, buy more stocks when prices are down and market pessimism is high.
2) Diversify your investments
Some financial guru's such as Robert Kiyosaki are not fans of diversification. However, for the average Joe investor diversification is important. Invest in the stocks of different-size companies in varying industries around the world. When assessing your investments’ performance, examine your whole portfolio at least once a year, and calculate your total return after expenses and trading fees.
3) Keep trading costs, management fees, and commissions to a minimum
These costs represent a big drain on your returns. If you invest through an individual broker or a financial advisor who earns a living on commissions, odds are that you’re paying more than you need to be, and you’re likely receiving biased advice, too.
4) Pay attention to taxes
Like commissions and fees, federal and state taxes are major investment expenses that you can minimize. Contribute most of your money to your tax-advantaged retirement accounts. You can invest your money outside retirement accounts, but keep an eye on taxes. Calculate your annual returns on an after-tax basis.
5) Don’t overestimate your ability to pick the big-winning stocks
One of the best ways to invest in stocks is through mutual funds and ETFs, which allow you to use an experienced, full-time money manager at a low cost to perform all the investing grunt work for you.
Common Mistakes to Avoid
1) Broker conflicts
Some investors make the mistake of investing in individual stocks through a broker who earns commissions. The standard pitch of these firms and their brokers is that they maintain research departments that monitor and report on stocks. Their brokers use this research to tell you when to buy, sell, or hold. It sounds good in theory, but this system has significant problems.
Many brokerage firms happen to be in another business that creates enormous conflicts of interest in producing objective company reviews. These investment firms also solicit companies to help them sell new stock and bond issues. To gain this business, the brokerage firms need to demonstrate enthusiasm and optimism for the company’s future prospects. Studies of brokerage firms’ stock ratings have shown that from a predictive perspective, most of their research is barely worth the cost of the paper that it’s printed on.
2) Short-term trading
Unfortunately (for themselves), some investors track their stock investments closely and believe that they need to sell after short holding periods — months, weeks, or even days. With the growth of Internet and computerized trading, such shortsightedness has taken a turn for the worse as more investors now engage in a foolish process known as day trading, in which they buy and sell a stock within the same day!
Whether you hold a stock for only a few hours or a few months, you’re not investing; you’re gambling. Specifically, the numerous drawbacks to short-term trading include higher trading costs, more taxes and tax headaches, lower returns from being out of the market when it moves up, and inordinate amounts of time spent researching and monitoring your investments.
3) Following gurus
It’s tempting to wish that you could consult a guru who could foresee an impending major decline and get you out of an investment before it tanks. Nearly all these folks significantly misrepresent their past predictions and recommendations. Also, the few who made some halfway-decent predictions in the recent short term had poor or unremarkable longer-term track records. As you develop your investment portfolio, take a level of risk and aggressiveness with which you’re comfortable. No pundit has a working crystal ball that can tell you what’s going to happen with the economy and financial markets in the future.
4) Avoid temptation and hype
This is a big one. Before you invest in any individual stock, no matter how great a company you think it is, you need to understand the company’s line of business, strategies, competitors, financial statements, and P/E ratio versus the competition, among many other issues. Selecting and monitoring good companies take research, time, and discipline.
Also, remember that if a company taps into a product line or way of doing business that proves to be highly successful, that success invites competition. So you need to understand the barriers to entry that a leading company has erected and how difficult or easy it is for competitors to join the fray.
Simply buying today’s rising and analyst-recommended stocks often leads to future disappointment. If the company’s growth slows or the profits don’t materialize as expected, the underlying stock price can nosedive.
As a young adult, you’re in a position to take more risks because you’re investing for the long haul. However, you should be careful that you don’t get sucked into investing a lot of your money in aggressive investments that seem to be in a hyped state. Many people don’t become aware of an investment until it receives lots of attention. By the time everyone else talks about an investment, it’s often nearing or at its peak.
Be wary of analysts’ predictions about earnings and stock prices. Investment banking firm analysts, who are too optimistic (as shown in numerous independent studies), have a conflict of interest because the investment banks that they work for seek to cultivate the business (new stock and bond issues) of the companies that they purport to rate and analyze.
Psychologically, it’s easier for many folks to buy stocks after those stocks have had a huge increase in price. Just as you shouldn’t attempt to drive your car looking solely through your rearview mirror, basing investments solely on past performance usually leads novice investors into overpriced investments. If many people are talking about the stunning rise in the market, and new investors pile in based on the expectation of hefty profits, tread carefully.
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