Even the best long-term investors will pick a dud stock every now and again or have to endure short-term market downturns that can result in temporary losses. Fortunately, disciplined, patient investors can overcome these mistakes and still make excellent investment returns in the long-run. Learning from mistakes is part of becoming skilled in any part of life. But the stock market is a dangerous place for investors who don’t know what they’re doing. Having a down year is one thing, but it’s difficult to recover from a 100 percent loss. Here’s a look at some investing mistakes that could completely wipe out your portfolio.
- Putting all your eggs in one basket.
No matter how large a company may seem or how safe a particular stock may appear to be on the surface, investing all of your money in a single company is a risky endeavor. It’s not just small biotechnology companies or Silicon Valley startups that go bankrupt. Enron, Washington Mutual, WorldCom and General Motors investors all learned this lesson the hard way. “Diversification is protection against ignorance,” Warren Buffett once said. By investing in a low-cost index fund, such as the Vanguard 500 Index Fund (VOO), long-term investors can avoid the possibility of a single accounting fraud or cataclysmic company blow-up costing them their entire investment.
- Day trading.
Far too many new investors see the wild swings certain stocks make on a daily basis and fall into the day trading trap. These traders assume that day trading is the shortest path to market riches. In reality, the opposite is almost always the case. According to a study by the University of California at Davis, only 1 percent of day traders use a trading strategy that is consistently profitable in the long-term. In other words, between inconsistent results and mounting trading commission fees, 99 percent of day traders are throwing away their money one trade at a time.
- Investing in penny stocks.
Both the Nasdaq and the New York Stock Exchange require all stocks to maintain a minimum share price of at least $1 per share. However, on the OTC Market, stocks can trade for as low as fractions of a cent per share. While day traders routinely drive some of these stocks up thousands of percent at a time, the vast majority of them eventually end up at or close to $0. There’s a reason the majority of these companies are not listed on major exchanges, where companies are required to regularly report financial statements and comply with listing requirements. It may seem like a good deal to buy a stock for $0.02, but a $0.02 stock can go to $0 even faster than a $20 stock can.
- Trading options.
Options trading can be extremely profitable and stock options can be an important hedging instrument for long-term investors. However, for traders who jump into the options market without understanding the risks, it’s extremely easy to lose every last dollar. In fact, one study of Chicago Mercantile Exchange data showed that three out of every four option contracts sold over a three-year period expired completely worthless. If a stock investment goes wrong, investors could take a 20 or 30 percent hit in a matter of months. If an option investment goes wrong, there’s a high likelihood of a 100 percent loss. To make matters worse, options contracts have an expiration date, eliminating the possibility that patience can save a sour investment.
- Shorting stocks.
It may seem like the risks and rewards of taking a long position in a stock and taking a short position in a stock are roughly equal. However, short selling stocks is a much riskier endeavor. When buying a stock, the theoretical upside of the investment is limitless. Early Amazon.com, Inc (AMZN) investors have enjoyed gains of 1,000 percent or more, for example. Potential losses, on the other hand, are capped at 100 percent because a stock’s share price can’t go lower than $0. For short sellers, that risk-reward imbalance is reversed. Potential gains are capped at 100 percent. However, if a shorted stock’s share price triples, short sellers lose 200 percent of their original investment.
- Following your instincts.
The same gut feelings that can guide people so well in every other area of life often lead investors down exactly the wrong path. There’s a long list of natural cognitive biases that every successful investor must overcome, including confirmation bias, representativeness bias and anchoring bias. Successful investors must remain disciplined in times that emotions like greed and fear are pushing them to make the worst investment decisions at the worst possible times. “Be fearful when others are greedy and greedy when others are fearful,” Buffett once famously said. Investors who make decisions based on what feels good in the moment can easily follow their instincts all the way to the poor house.
- Believing any investment is a sure thing.
When it comes to investing, there are absolutely no certainties. Americans lost millions of dollars in real estate investments during the bursting of the housing bubble in 2007 and 2008. Many of these investors believed the U.S. housing market was a sure thing. Stocks, gold, oil, bonds, real estate, and even the U.S. dollar have all experienced…
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