Good evening cheapskates! Today marks the start of a new series for beginners on CI that we’re calling – popular finance and investing google searches – not so catchy we know, but we’re working on it. Before we get into answering the question, a little on why we’re doing this. To cut a long story short, we are regularly reading through the interwebs, researching and gathering information for our articles and can’t help notice the questions in the ‘people also searched for’ feature that google shows on it’s results pages.
Sometimes we assume our readers already know a little about investing (and if you don’t, our beginners guide to investing is a great place to start!) but the types of questions being asked the most are around the basics, leading us to believe that people want to start investing, they’re just not sure how.
This is further backed up by some worrying stats – a mere 3% of individuals in the UK subscribe to a stocks and shares ISA (which is worrying because as far as investing vehicles go worldwide, the UK stocks and shares ISA is an absolute powerhouse and is uncharacteristically generous!). Not only that, but on average, people only hold onto their investments 0.8 years compared to 9.7 years in 1980, which is a decline of 91.75%. Part of the reason for this is a lack of financial education – there is a great deal of misunderstanding when it comes to the stock market, from worrying about the dangers to feeling that the process is too complicated.
But thankfully, CI is here to shine a light in the investing dark. Ready? lets jump in.
As always, the following is not financial advice, read our disclaimer
“The biggest risk of all is not taking one”Mellody Hobson
Can I lose money in the stock market?
The simple answer to this question is – yes. In fact, you can lose all of your money the very next day you started investing. Scary!
BUT, If that’s the case, why do people do it and how to people become rich doing it?
You see, the long answer to the question is not as straightforward as the short one. It’s true, you can lose money in the stock market, however we feel that if done right and by employing simple principles, losing money doesn’t really pose much of a risk and will set you on the right path to building your personal wealth. It’s important to remember that whilst you could in theory lose 100% of your investment (for the purposes of this article were going to be talking about investing in actual stocks, not CFD’s, borrowing, leverage etc, which we would recommend against anyway) you could make an unlimited amount, so the theoretical upside of stock trading is always more than the downside. All of the top 10 richest people in the world invest (and Warren Buffett made his fortune entirely by investing) so clearly there’s something to this. Below, we delve into why people lose money in the stock market and we list the mistakes we avoid to help minimise your risk and ensure you growing your wealth.
How people lose money in the stock market
There are a number of reasons that people lose money in the stock market which we will delve into – but simply put people lose money by investing in a stock or commodity that decreases in value. Once that asset has decreased in value, they sell it and are left with less money than they originally invested. The stock market is a big game of supply and demand. If there are more buyers than there are sellers of a stock, the price will increase until there are enough people willing to sell to meet the demand. Conversely, if there are more sellers than buyers, the price will keep going down until there are enough buyers willing to buy at the new lower price to stabilise the price.
So, the key to not losing money is, don’t invest in assets that go down in value right?
Correct! But that is far easier said than done. You could invest in a great company that’s seen fantastic growth recently like Amazon, but tomorrow the company announces some sort of scandal and all of a sudden, the stock drops in value. The truth is, no one can predict exactly what stocks are going to do and that’s because of a number of factors:
People are emotionally stupid
We published an article recently on investing FOMO which covers a lot of this concept, but in a nutshell, as humans it’s very hard for us to make completely logical investing decisions without our emotions getting in the way. Money is an emotional thing, it’s so integral to our every day lives and has the power to change our futures, so naturally the prospect of making a lot of it, or losing it, is an emotional thing. On top of this, everybody suffers from ‘confirmation bias’. This basically means that the brain is hardwired to think that things will continue as they have recently. Stock gone up for the past month? then it probably will for the coming months right? Not necessarily, but our brains think like that. Layered on top of all of that then is FOMO. In a world of social media and instant news, we as investors are continually surrounded by news of the latest stock going to the moon! We then see our friends, people we know making good money from the latest stock trend and think – “maybe I should get in on that”. As a rule of thumb, if your friends have heard about it or you’re hearing it in the news, it’s already too late. Humans are exceptionally poor at controlling their emotions when it comes to decision making but understanding these flaws will help you make better investing choices
Bad luck – but worse strategy
The other reason people lose money is because of something we cant control – luck. You could have done all of the research on the world on a particular company, their balance sheet is healthy, the price is good, they have long term appeal with no debt and a solid structure. The next day though, the stock tanks because a meteor hits their facility. Ok that’s an extreme case but it illustrates that sometimes things are out of control. HOWEVER – that doesn’t mean that we can’t protect against it. Sure, you can have some bad luck on one stock. But if that bit of bad luck has a major impact on your investing portfolio and your wealth growth, then you’re doing something wrong. You’ll hear people say that they were unlucky with their stock pick – when in reality all that means is that their strategy is poor. Luck is something that affects us at a casino, but out here in the stock market, it doesn’t have to be a gamble. By avoiding the mistakes and with a good strategy, you can take luck out of the equation.
Mistakes to avoid
1. Putting all of your eggs in one basket
Bad practice in many aspects of life, but is especially true when it comes to stocks. In the investing sphere, investing in many stocks to lower your chance of losing your money is called diversification. If you put 100% of your investment into 1 stock and that stock runs to zero, you risk losing 100% of your money. However, if you invest your money into 10 stocks equally and one of them goes to zero, you’ve only lost 10%. The trick is to invest in a nu,ber of good stocks that you believe will give you a good return on your investment. If you’re wrong on some of them, the impact is less because the others should make up for it. A good benchmark to aim for is the S&P 500 US stock index. This index is a collection of 500 of the top US companies and on average increases in value 7-10% per year. If you can achieve this return or more with your stock picks then you’re on your way to good portfolio performance.
You could however take the guessing completely out of it and invest in an ETF. An ETF is a stock that tries to emulate the performance of an index, for example the S&P500. This way, you can invest in a single S&P 500 ETF stock and instantly get the diversification of 500 of the best US companies. Nice.
Word of warning though – there is something called over-diversification, where you invest in so many stocks that your potential for returns diminishes. You might be tempted to invest in 1000 stocks to really lower your risk, but doing this will also hurt your returns (not to mention it will be a logistical and book keeping nightmare). Just as diversifying means your worst stocks will have less effect on your portfolio, over diversifying will mean your best stocks will have less effect on your portfolio. We favour picking a good 20-25 stocks that include some good ETF stocks as a base.
2. Not doing your homework
“Never invest in a business that you don’t understand”
As Mr. Buffett says above, don’t invest in something that you don’t understand. That’s a simple way of saying before you go investing in something, its important understand the stock, other wise how can you be sure that the price you’re paying is worth it? Think of it this way – let’s say you want to invest in Apple. The main reason that you would invest in Apple is because you think you’ll get more money back from it at some point in the future. That means you think that Apple is going to grow in the future. But what if you had 2 trillion dollars (enough to buy Apple) would you buy the entire company? If you are sure that apple is going to give you a good return in the future, why not? You would probably do a lot more research before pulling that trigger. The thing is, because most retail investors (you and me) usually invest relatively small amounts every month, we tend to do less research before investing in a company, but we should be as confident in a stock giving us a return for small amounts as we would be if we were buying the whole company.
Doing research in the company is called fundamental analysis. Basically, this means how good is the company fundamentally in terms of it’s potential to give you a return. We won’t dive into the detail here (head on over to our investing section for more on that) but understanding the companies balance sheet, its debt, it’s current operations, it’s earnings and its future growth potential should set you on the right path.
3. Trying to time the market
You’ve heard the old adage, buy low and sell high. It’s probably the most obvious piece of advice in investing but is also pretty dangerous. You see, most people are just awful at telling when a stock is low and when it is high – us included. Because we are emotional creatures, when a stock is doing really badly, some people see a stock that is undervalued so will think of investing. Others will see a badly performing stock that’s losing money for it’s investors. The same goes for when a stock is high. The thing is, no one can consistently judge wether the stock will go up and down.
What we do know is, that on average, stocks – and the broad market – goes up on average 7-10% per year. So, we like to take the guesswork completely out of it and invest in a diverse range of stocks, usually through a whole market ETF, every month without fail, regardless of that the stock price is doing. This method is called ‘dollar cost averaging’ and ensures you pay the ‘average’ price over time. Even then, there’s no guarantee that we will make money every year but history tells us we should make money over time – especially if we stay invested for longer. Sure, we buy a number of well researched stocks in an effort to beat an average return, but these do not make up the bulk of the portfolio.
You might think that doing this is a fools errand, returning a measly 7-10%. But trust us, 7-10% per year every year is a good return and soon begins to snowball. Bear in mind that almost all professional wall street investors fail to beat the market every year, so by using this method you’re almost guaranteed to beat the majority.
4. Selling too often / quickly
Leading on from the above, trying to time the market is bad, but not giving it enough time is equally as bad. Familiarise yourself with this saying:
“Time in the market beats timing the market”
– All decent investors
You see, the most important tool you have in your arsenal when it comes to investing is TIME, even more than the money you’re investing or the stocks you’re picking. This is because of 2 reasons. the first is that short term, the price of a stock or ETF can be volatile and can sometimes lose you money quickly, especially when you consider fees. But over time, if you’ve done proper research, that stock is likely to rise should continue to do so over time (if it isn’t likely to rise, then you shouldn’t have invested in it). The second factor here is called compounding. This means that the interest you earn on your portfolio, earns you more interest when reinvested. And the interest on the interest earns you more interest and then – you get where were going. Take this example of investing £500 every month over 30 years:
|1 year||15 years||30 years|
As you can see, the interest after 1 year is a measly £256, but over time, the interest begins to snowball and in year 30, the interest is worth almost 3 times the money you invested!
It’s easy to succumb to fear when your portfolio drops in value and it seems like everyone is getting out to protect their money but the key is to hold strong and hold your position.
5. Trying to be too clever
This last one not everyone will agree with but if you’re a new investor, and in most cases even if you’re not, we would stick to traditional investing – i.e investing in the actual stock and company itself.
If you don’t know what we mean by that, We’re talking about CFD’s, calls, puts, options and other types of fancy investing. You’ve probably seen the warning signs on some of these investing platforms, usually in the small writing at the bottom of the adverts that read – “76% of retail investor accounts lose money when trading spread bets and CFD’s with this provider”. This should instantly give you alarm bells – it does for us.
The basic premise of these types of investments is that you aren’t investing in the underlying asset at all, usually you are investing in a contract with the investment provider on the price of a stock going up or down. These types of investments are particlarly dangerous because you can BORROW money against your position, this is called LEVERAGE. It means you only need to put down a percentage of the money you’re investing but will still benefit from the bigger return of your stock moves in the direction you predict. The problem is, even though you can amplify your profit, you can also amplify your losses too. On top of that, because of the fees usually associated with these kinds of investments, people tend to hold onto these positions for less time, meaning that your investment usually isn’t time to grow
Some of the biggest trading platforms in the UK (like Etoro, Plus 500, CMC markets) provide these kinds of trades, so it’s easy to get confused. In some cases, these companies purposely advertise these services as true investments. We steer clear from these and stock to regular investing.
Thanks for reading! Head on over to our investing section HERE for more investing, stocks and wealth articles!
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