Novice investors have had a rough introduction to stock markets over the past three years. The global credit crisis, which caused markets around the world to plunge in 2008-09 and is still creating aftershocks, has left investors badly shaken.
You can't control the markets. But what you can control is how you respond to them. Let's review some common investing errors that beginners are particularly prone to making, and how you can avoid them.
Mistake #1: Playing it too safe
Young, inexperienced investors are generally fearful of making mistakes. So they'll tend to keep all or most of their savings in low-interest saving accounts. The problem with this approach is that over a long time horizon, low-risk vehicles like savings accounts or GICs are likely to yield much lower returns than stocks.
Sure, stocks are riskier. But if you are a young long-term investor, you have a longer investment horizon. For that reason, you should be able to tolerate greater risk, thus increasing your return potential. And if the markets take another plunge, you'll have adequate time to make up for those losses.
Mistake #2: Disregarding risk
Assuming that you won't play it too safe with your investments, don't disregard risk either.
If you are tempted to invest in a hyped-up stock, remember that periods of spectacular performance don't often last, and that speculative bubbles can burst. A classic example is the collapse of the former high-tech giant Nortel Networks Corp., which by April 2000 had grown at such an astounding pace that it made up a third of the total market capitalization of all the companies listed on the Toronto Stock Exchange. Then technology stocks plunged and so did Nortel, to pennies per share from its peak of $124. Today Nortel is under bankruptcy protection.
The trick is finding the right balance between safety and growth potential, and investing in a combination of funds or other products that fit with your tolerance for risk. This is easier said than done, and at first you may need some help from a financial advisor to determine the asset allocation that is right for you. Also, through experience you may discover that you actually can tolerate more (or less) risk than you initially thought.
Mistake #3: Reacting emotionally to headlines
The problem with news headlines is that if investors don't look beyond them, they can be misled into taking inappropriate actions. Furthermore, headlines encourage investors to make decisions based on emotion, which is never a sound investment strategy.
Consider, for example, British Petroleum PLC BP, which has been in the headlines relentlessly since the drilling-rig disaster in the Gulf Of Mexico in April. BP is a massive company, well represented in many portfolios, and was long considered a market darling for its steady and often increasing flow of dividends. The highest price on record for BP's American Depositary Receipts (ADRs), which trade on the New York Stock Exchange, is US$77.99 per share in October 2007.
Two and a half years later BP had plunged to a low of US$27.02 as it struggled to halt the massive oil spill.
Reacting to these losses and to the continuing stream of negative headlines, a fearful investor might conclude that the time to sell is now.
However, with the out-of-control well having been capped, BP stock has been slowly regaining lost ground. On Monday, it closed in New York at US $40.86 per share. Is BP on the verge of collapse? Evidently not, but many investors who reacted to the headlines probably believed otherwise.
Mistake #4: Trying to time the markets
The strategy of timing buy and sell decisions on stocks based on attempts to predict future market movements is not recommended for beginner investors. Essentially this amounts to taking your money out of the stock market when you think it's about to fall, and putting it back in when you think it's about to start going up.
Sounds reasonable, right? The problem is that it's basically impossible even for seasoned professionals to get such predictions right consistently. There are too many variables involved, especially in a volatile market like what we have seen in the past two years. For novice investors, trying to time the markets really amounts to no more than guess work.
Also, turnaround points in the markets tend to happen very fast, so if your timing is a little off you risk missing out on the lion's share of the recovery and bearing the brunt of a market drop. It's better to find the asset allocation that's right for you and stick to it for the long term.
Another problem with market timing is that it requires frequent trading, which costs money. For investors with a tight budget, spending $5 to $25 per trade can get expensive quickly.