Investing is not easy, and even those who have been investing for many years make mistakes. In this article, I point out three common mistakes that are common among beginning investors. By avoiding these mistakes you won’t necessarily be successful right away, and you will likely make several investing mistakes that will ultimately make you a stronger investor. However, by recognizing that beginning investors have a tendency to make the following mistakes, you can avoid them and hopefully become a successful investor that much quicker.
1. Buying a stock because it looks cheap
Many investors think that just because a stock looks cheap that it offers good value. There are many qualities that can give you the impression that a stock looks cheap such as a low P/E ratio, a high dividend yield, or a high analyst price target relative to the current stock price. In fact many investment websites offer stock screening software — including popular ones such as Google Finance — that will screen for these sorts of things. However, you need to realize that while the market isn’t efficient, stocks that look cheap are not always cheap. For instance a low P/E ratio can be the result of a one-time gain such as the sale of an asset. It can also be a warning sign that analysts expect that the company’s earnings will fall in the following year.
If you are planning on buying a stock that looks cheap based on one or more factors, make sure you understand why it looks cheap. Also keep in mind that there are wealthy investors out there who have more experience and better access to information than you, and if the stock really were cheap, then these investors likely would have bid the price up. So a “cheap stock” may also be a stock that you don’t fully understand or that the market doesn’t understand, and as a beginning investor you want to avoid these — be willing to pay a little extra for simplicity.
2. Buying a stock because you are familiar with the company’s product
A common piece of investing advice is to “buy what you know.” Beginning investors often equate this with buying stocks of companies that produce products that they use, and therefore “know.” This can be a very dangerous attitude to take. On the one hand it can be lucrative: if you use a product and know that it is popular, but the market fails to recognize this fact, then your grass-roots knowledge could be valuable in helping you make an investment decision. But it is a bad idea to do this without extensive research.
Generally it is a bad idea to, for instance, buy Ford (NYSE:F) shares just because you own and like your Ford. Therefore avoid this common rookie mistake, and instead amend the above advice in your mind to the following: “use what you know as a consumer in order to come up with potential investment ideas.” So if you like your Ford this may give you reason to investigate Ford as a possible investment. Think of the difference as that between “probable cause” and “beyond a reasonable doubt.” Liking your Ford gives you probable cause to investigate Ford as an investment, but it doesn’t make it a good investment beyond a reasonable doubt.
3. Diversifying too much
One piece of investing advice that is common knowledge is to diversify. And you should follow it. But keep in mind that you need to do research to make investment decisions. If we look at two extreme cases — owning five stocks in the same sector versus owning five stocks in five different sectors — it becomes clear that if you do the research for the former portfolio that your knowledge of each stock will add to your knowledge of the other four. You get to learn the jargon of the industry, what a reasonable rate of return on invested capital is, who is successful, and so on. But in the latter case you need to do a lot more research in order to become equally as proficient in five different sectors.
So you need to diversify. If one sector falls out of favor you need to have investments in another so that your losses aren’t tremendous. But at the same time if you diversify too much you are spreading yourself thin. So before investing, you need to realistically determine how much time you have to research your investments. If you have a lot of time, then investing in five sectors might be feasible. But if you don’t you need to specialize or else your diversified portfolio will be chosen blindly, and this is very dangerous.
Disclosure: Ben Kramer-Miller has no position in the stocks mentioned in this article.