- Date : 23/10/2020
- Read: 6 mins
Learn about six common stock trading mistakes and how to avoid them.
It has become common knowledge that merely saving money is not enough - you must invest your earnings to secure your financial future! However, investing in the stock market isn't easy as it comes with its own set of challenges, risks, and consequences.
While trading in the stock market may seem like gambling, one can capitalise on the volatility by making well-informed and prudent decisions and avoiding some beginners' mistakes. Read on for a list of six common investing mistakes you should be aware of.
1. Hoping for quick returns
A common mistake people make with equity investments is expecting their money to increase manifold overnight. This leads to greed and can result in overtrading. Or one may resort to intraday trading or speculation based on tips to get quick returns. For example, legendary investor Warren Buffet bought six shares of his first-ever stock (Cities Service) at $38 per share and sold them at $40 per share. However, the share price touched $200 soon afterward.
Pro tip: When you are investing money, you should also be prepared to invest time in the stock market. Assuming you have decided to invest in the right company, all you need to do is wait patiently for your money to multiply. The returns from stock market investments are ideally suited to help accomplish your long-term goals such as buying your dream house, funding your children’s education, starting your own business, etc. If you are patient enough, stock market rewards can certainly help to secure your financial future.
2. Investing in small caps
Another beginner mistake to avoid is investing in small-cap companies. Investing in small caps can seem very lucrative, especially when you hear stories like ‘XYZ stock price increased from Rs 10 to Rs 75 in a week’. However, these great returns from small caps are rare. More often than not, the volatile movements of small-cap industry prices can cause huge losses.
Pro tip: On the other hand, small-cap investments can give good returns if one picks the right stock to buy. The trick of picking good stocks comes with efficient research and investment experience. As a rule of the thumb, it might be wise to avoid investing in small caps with dreams of your money doubling overnight and instead stick to shares of well-known companies.
3. Falling for the ‘talk of the town’
An essential factor that determines the level of return you get for your investment is the timing of your investment. If you invest in a stock after reading about its performance in the previous week, you are investing in a past price movement. This might not be the best investment, as your return is dependent on the stock's performance in the future and not the past. Moreover, past increases in price are not sure-shot indicators of future growth. It often occurs in the market that the stock price slumps after a steep rise.
Pro tip: If you have to or wish to buy a stock that is making headlines, invest in it with a long-term perspective. This will make sure your stock value is offset from short-term fluctuations. It is also recommended that you conduct your own research about the fundamentals of the stock instead of relying on borrowed knowledge.
4. Not paying heed to diversification
New investors commonly lack essential diversification in the portfolio. By concentrating their investments in one or two stocks, they hope for blockbuster returns. This often fails to deliver the expected results.
Pro tip: Concentration is recommended for those who have in-depth knowledge about the stocks they are investing in. Diversifying investments involves buying stocks across industries having varied exposures to economic fluctuations, thereby adequately diversifying the portfolio risk. This will ensure the right balance of securities in your portfolio to hedge chances of significant losses with market volatility.
5. Aiming for bigger profits through margins
Margin trading can be used to buy shares at a price lower than their actual price by leveraging the funds in your account, with the promise of paying back the margin amount with interest within a specified time (usually a matter of days). This can seem a lucrative proposition as it lets you buy high-valued shares at a lower price with the hopes of the money multiplying - allowing you to return the margin amount and also make a tidy profit. However, this hardly plays out in an ideal manner in the market; it can increase the intensity of your losses if things go bad.
Pro tip: New investors are advised to stay away from leveraging margins to buy stocks. If at all you do so, use it to buy stocks from reputable companies and use your own money for the riskier or more ambitious investments.
6. Not using stop-loss orders effectively
A stop-loss order is an order that is placed with your broker/portfolio manager that instructs them to buy or sell a stock once it reaches a pre-determined price. For example, if you have bought a share worth Rs 200 and place a stop-loss order for Rs 180, you ensure that the maximum loss will be Rs 20. The stop-loss order ensures that your stocks are automatically sold if the share value plummets to that level. For new investors, not using stop-loss orders is a crucial mistake as it can significantly mitigate losses and reduce risk. Newbie traders end up losing their capital largely because they don’t practise stop-loss.
Pro tip: Stop-loss is arguably the most important practice in trading. Trading is as much about human behaviour as it is about numbers and charts. Even if one has mentally set up a stop-loss order for a stock, one may not execute the sell order due to lack of discipline. Therefore, it is recommended that traders set a stop-loss when the trading session begins rather than waiting for the stock to hit stop-loss.
Rome wasn't built in a day, but Hiroshima and Nagasaki were destroyed in seconds. The same is the case with your investment career. Wealth creation happens over the long term, but you can blow up your entire account by committing these common mistakes.
Disclaimer: This article is intended for general information purposes only and should not be construed as investment or tax or legal advice. You should separately obtain independent advice when making decisions in these areas.