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If you've been saving your money for awhile, then you're likely to have a sizeable amount you can invest. The reason you’d want to invest your savings is to obtain a steady income stream while keeping up with inflation. But this also means coming face-to-face with the risks of stock market crashes, economic downturns, and investment losses.
Don’t stress! This article sheds light on the most common mistakes made by first-time investors and provides tips to minimize the risk of losing your hard-earned savings in tough economic times. Read on to find out about these easily avoidable mistakes and their solutions.
1. Investing in a Business You Don’t Understand
This is one of the most common mistakes made by first-time investors: they invest in an enterprise with a business model that they don't fully comprehend. This can turn out to be a grave mistake, as you have to understand a business to judge its prospects. Rather than trying to understand a company’s business model, many novice investors are more interested in the hype that surrounds it – which can cost them in the long run.
As you would expect, an astute financial investor will assess a company’s financial performance and revenue before investing in it. They will base their final decision on facts and statistics rather than hearsay and marketplace rumours. This advice comes straight from billionaire Warren Buffet – one of the most successful investors of all time.
In case you don't want to go into the details of each business and still want a diversified portfolio, you should select mutual funds or exchange-traded funds. But if you're interested in purchasing individual stocks from a promising enterprise, then make sure you do your research and understand what the business is about.
Finding an online brokerage that offers plentiful research options is crucial. Questrade is one of our favourite discount brokerages in Canada, and their pricing is very competitive. Not only do they offer free ETF purchases, but they also provide a robust research tool that delivers quotes, screeners and research right in your trading platform — free of charge. Sign up for an account today, and get $50 in free trades.
2. Making Emotional Decisions
When it comes to investing, there’s no place for emotional decisions since this involves your lifelong savings – which you cannot afford to lose. No matter how well the company has performed in the past, if you notice that the fundamentals for which you purchased the stocks have changed, then you should consider selling them.
Fundamental analysis involves an assessment of company details like return on assets, cash flow, capital management, profit retention history, conservative gearing and other factors. This analysis entails the scrutiny and evaluation of all information about the company, besides its stock trading patterns. Remember you invested in the company to make a profit, not because you were enamoured with it.
If you have trouble keeping control of your emotions (which, as investors, is normal), a robo advisor can help invest on your behalf in a much more pragmatic way. Wealthsimple is hands-down our favourite robo advisor right now, but there are several other options for those looking for a top-notch robo advisor. Make sure you check out our comprehensive review of the best robo advisors in Canada.
3. Failure to Diversify
As a new investor, you should seek to diversify your portfolio to mitigate your risks. You can do this by building a balanced portfolio of mutual funds or exchange-traded funds. For those looking to invest on their own and do some DIY investing, we highly recommend Questrade – one of Canada’s top online brokerages. Not only is their platform easy to use and navigate, but they provide you with plenty of research options to let you craft your own portfolio the way you want.
If you’re not comfortable with the idea of DIY investing, we recommend a robo advisor to help you build a balanced and diversified portfolio out of the gates, based on your level of risk tolerance. Right now, Wealthsimple is at the top of our list as it has a beautiful interface, tons of options, and highly-competitive pricing.
Seasoned investors are capable of making the right decisions on individual stocks based on their experience and expertise. New investors try to emulate this only to suffer deep losses. If you're new to investing, you should never invest in individual stocks. This is something that only the most experienced investors should be doing because they have the requisite knowledge and skills for such high-risk trading. The adage of putting all your eggs in one basket appears to be most apt for new investors.
As you gain experience and knowledge about the nuances of investment, you can then try investing in individual stocks. This should only be a small percentage of your portfolio initially. Even then, you should try to maximize diversification by investing across all major sectors. As a general rule, avoid allocating more than 5 percent of your money in any one asset.
This investment method has the potential to minimize losses if some sectors are performing poorly. Quite often, when specific industries are suffering a downturn, other sectors are performing better. Thus, diversification can lead to lower overall losses across all industries, even if the economy is sluggish.
Some people argue that diversification can also result in a lower yield, much in the same way as it minimizes risk. This is undoubtedly true because lower risk means lower returns. However, the overall rate of return of your investment will be quite decent, considering that stocks have historically grown at an average rate of 10 percent.
This average takes into account all the major financial disasters and recessions. A 10 percent rate of return is quite decent in terms of portfolio performance. This is certainly not a bad start for first-time investors. To obtain high returns, they need to obtain the know-how and skills required for high-risk trading.
4. High Investment Turnover
Investment turnover refers to the rate at which securities are sold by a security holder. For example, if a mutual fund holds $100 million worth of stocks and sells off $30 million value of stocks during a specific year, then the investment turnover is 30 percent.
Very high investment turnover is not a good idea since it leads to increased transaction costs, which can offset the gains from investments. Investment funds with a high turnover are not a good option for investors. Nevertheless, actively managed portfolios offer a higher turnover than passive funds.
High investment turnover is not advised unless you're an institutional investor who can leverage low commission rates. In this particular case, the transaction costs and taxes will be too high. There is also the possible opportunity cost (lost earnings) since you will miss out on gains if the stock sold appreciates steadily in the long run.
Jumping from one investment product to another product does not offer good returns over the long term.
5. Market Timing
This common misconception is closely related to investment turnover. Although market timing has support from some active traders, one thing remains certain: timing the market can be challenging, especially for new investors who have limited understanding of the market.
While it is true that professional-day traders and some investors use economic forecasts, chart analysis and even their intuition to predict the market, hardly anyone can always do it with consistent accuracy. Market timing does not yield significantly greater returns than the buy-and-hold strategy wherein investors purchase and hold stocks over the long-term.
Economists are known for making wildly inaccurate predictions. A study by the Federal Reserve in the US showed that despite in-depth statistics and fancy computer models and algorithms, economic forecasts are still erroneous.
The gap between the prognosis and reality appears to be widening since the 2008 financial crisis. This astounding finding has startling implications. The bottom line is that the market cannot always be predicted.
So, if you hear about an example of successful market timing, then it could have more to do with luck than logic. A widely cited study, “Determinants of Portfolio Performance” says that asset allocation decisions are a better explanation for portfolio performance rather than market timing.
Timing the market is a pain and making sure your portfolio is allocated properly at the right time can be even more mind-boggling. That’s why we recommend using a robo advisor to help make this process easier for you. Be sure to look at our full list of the top robo advisors in Canada this year.
6. Lack of Patience
As they say, slow and steady wins the race. Success is often the result of many years of hard work and perseverance. Any instances of overnight success are few and far between. In the majority of cases, people face multiple hardships and impediments in achieving their goals and dreams.
In particular, investing is not always smooth sailing. You’ll undoubtedly face periods where you’ll suffer losses or make a low profit. Remember, successful investors keep a steady head rather than get flustered. They don't make impulsive decisions in the face of difficulties.
So, you should always keep a realistic expectation from your portfolio and never make a rash decision. If it’s too good to be true, it probably is. If a company promises high profits in little time with a given trading technique, you should be skeptical and do your research. There might be a catch somewhere, so make sure to do your research. If the rewards are so high, why isn’t everyone else doing it? This is the first thought that should come to your mind when you're faced with such promises.
With smart investment decisions, your portfolio will be able to yield a sizeable return over time.
7. Trying to Break Even on Losing Stocks
Unfortunately, new investors have a propensity for clinging on to declining stocks even when the writing is on the wall. The wisest course of action in such cases is to curtail and cut short your losses by getting rid of plunging stocks before they fall further.
However, some investors hold such stocks, hoping that they would rebound and allow them to recoup their losses. Sadly, this will not just exacerbate their losses; it will also cancel out profits (if any). Their rationale is based on what behavioural finance refers to as “cognitive error.”
Not only will this fallacy deteriorate losses and offset profits, but it will also lead to opportunity costs, that is, lost earnings – money gained by selling these plummeting stocks could have been invested in lucrative stocks that would have yielded dividends and capital gains.
This behaviour is not unlike that seen in gambling where punters chase their lost bets with more wagers hoping to offset them, but ultimately, they end up aggravating their situation.
8. The Herd Mentality
“Panic-selling” is a real thing: when a market downturn happens, a lot of investors get spooked and sell their stock. But savvy investors don’t follow the crowd blindly. They know that stock market downturns are normal, and the best strategy is to “buy and hold” while the market goes up and down. For instance, Bank of America Merrill Lynch found that investors who buy-and-hold outperform panic sellers every decade back to 1960.
Shrewd investors also see opportunities in a downturn. Some of the most successful investors have taken advantage of stock market crashes to buy shares at rock bottom prices, which later proved to be highly lucrative. Of course, you may have to contend with low yields during an economic crisis. However, you will get much better returns when the situation reverts to normal. Keeping in view the historical performance of stocks, the average yield will be in the region of 10 percent.
Long story short: avoid the herd mentality. No matter how badly the market fluctuates, stay calm and remember that stock prices and yields will likely rebound within 18 months. If you’re having a hard time fighting your emotions, there’s an easy solution: set up automatic deposits to a robo advisor or discount brokerage. By making your contributions automatic, you’ll avoid the temptation to hold off investing.
With a robo advisor, you don’t have to worry about herd mentality or panic-selling. The algorithms built behind robo advisors like Wealthsimple take the emotion out of investing and place logical trades at the right times, based on data.
If you’re using an online brokerage, you may think you’re at a slight disadvantage here, since you’ve opted to do some DIY investing. But that’s not true at all. While self-directed online brokerages aren’t going to tell you which stocks to buy and sell, they offer a plethora of resources to help you make more informed decisions, such as research reports, news articles, and in-depth analysis of stocks. Questrade does an awesome job at this, and you can even contact them for help in executing trades or finding the right resources.
After reading the most common mistakes made by first-time investors, you can avoid the path to a financial disaster. If you're a new investor, take the time to evaluate which method you want to invest with – guided, DIY, or robo advisors – so you can determine the level of involvement you’ll need to avoid mistakes.
If you plan to work with a financial advisor, having a strong relationship and a keen understanding of what they’re doing with your money is critical. If you’re a DIY investor, making sure you take the time to stay on top of research and news is important.
Finally, if you’re using a robo advisor, it’s mostly hands-off, but not completely. Make sure you’re checking in on your portfolio’s progress and evaluating your risk tolerance every so often.
For DIY investors, we strongly recommend Questrade due to their low cost and excellent research options (plus, the fact that we’re giving you $50 in free trades doesn’t hurt either). To help cut costs a bit (both for your time and money), you can also use a robo-advisor. We also like Wealthsimple due to their low cost, excellent customer service, and ability to get into socially responsible investing. Plus, take advantage of our promo code that gives Young and Thrifty readers their first $10,000 of assets managed for FREE for a year.
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