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Trading Lesson: Temper Expectations, Start Small, Take Measured Risks
02/01/2018 4:33 pm EST
The basics sound simple in theory—buy low and sell high, that’s it! How hard can that be, right? To make money, you have to know what “low” and “high” really mean, writes Steve Pomeranz, CFP. Look for guides on how to get started trading every Friday on MoneyShow.com.
Remember the first time you heard about the stock market? I’m sure it got the adrenaline up for many of you: excited about picking stocks, with dreams of doubling, tripling and 10x-ing your money, the early days when you hadn’t tasted your first loss of capital and were completely unaware of the dangerous pitfalls of inexperienced, untrained, and over-confident investing. It’s almost like a rite of passage, where the market quickly hazes newbies and shows them that it’s the one that’s all powerful.
So, for those of you who are new to investing or trading, let me give you a few tips on how you can keep from getting burned by the market.
Jumping in head first
The basics of investing sound really simple in theory—buy low and sell high, that’s it! How hard can that be, right? Well, you’ll be surprised. To make money with this simple strategy, you have to know what “low” and “high” really mean.
Remember, in the stock market, when you buy, someone else sells; and when you sell, someone else buys. So, what you may think “high” as a seller of shares could be considered “low” (enough) by the buyer in any transaction. Are you really smarter than your anonymous counterparty?
See what I mean, how different conclusions can be drawn from the same information? Because of this hard-to-pin-down relative nature of the market, it is important to study up a bit before jumping in. It’s really never as simple as buy low and sell high. I always say that investing is simple, but it’s not easy.
Before you start investing on your own, I do believe you should read up on basic accounting so you understand terms such as revenue, revenue growth, operating expenses, operating profit and earnings per share that feature in a company’s income statement.
It’s also important to understand terms such as cash, total assets, current assets, goodwill, total liabilities, current liabilities, and owner’s equity (also called book value), which are features on a company’s balance sheet. And terms such as working capital and cash flow, so you’re in a slightly better position to truly assess a company’s financial position before you jump on someone’s recommendation to buy a “hot” stock.
In addition, it’s also important to understand a few basic metrics that let you gauge a company’s stock price relative to its financials—terms such as book value, dividend yield, price-to-earnings ratio (P/E) and so on. Understand how they are calculated, where their major weaknesses lie and where these metrics have generally been for a stock and its industry over time, so you can compare a company’s stock valuation relative to its fundamentals and relative to its competitors or the market as a whole.
While you are learning, it’s always good to start out by using virtual money in a stock simulator. Most likely, you’ll find that the market is much more complex than a few ratios can express, but learning those and testing them on a demo account can help lead you to the next level of study.
Playing penny stocks and fads
Let’s talk about penny stocks. At first glance, penny stocks, which literally cost less than a dollar per share, seem like a great idea to invest in. With as little as $100, you can get a lot more shares of a penny stock than of popular companies such as Facebook (FB) that costs about $136 per share or Alphabet/Google (GOOGL) that costs $830 per share… right? And, you may be tempted by the sizable upside if a penny stock goes up by a dollar.
But remember: a penny stock is a penny stock for a reason. The market doesn’t believe the company warrants a higher valuation and that the company may not offer much future gain. What penny stocks offer in position size and potential profitability may reflect high volatility and poor expected returns.
So even if you buy a stock for 50 cents, its higher volatility means you could end up losing the entire 50 cents should the company tank. That risk is much less with a Facebook or a Google.
Penny stocks are also exceptionally vulnerable to manipulation and lack of liquidity. Getting solid information on penny stocks can also be difficult because many reputed investment companies simply do not follow them, making penny stocks a poor choice for an investor who is still learning. So, beware! Penny stock pushers would love to con you into thinking they’re the path to riches, while that’s true rarely, and most of the time, people have lost big on penny trades.
As a matter of fact, on Facebook, I now see ads for the promise of making millions on penny stocks of companies involved in the commercialization of marijuana. There are no easy riches and most who get into this are going to lose everything. It’s been said: “There’s a sucker born every minute.”
Overall, I’d prefer you own a quality stock for a long time than trying to make a quick buck on a low-quality company.
Going all in with one investment
Investing 100% of your capital in a specific investment is usually not a good move, not even in a Google, Microsoft (MS) or Facebook because even the best of companies can face issues down the road and see their shares decline dramatically.
While you might have more upside if you go all in and the company does really well, you also have a lot more risk. Especially as a first-time investor, it’s good to diversify and buy at least a handful of stocks. This way, the lessons learned along the way are less costly but still valuable.
Another dangerous move is leveraging your money by using margin. Using margin means that you borrow money from your broker to buy more stock than you can afford. Using leverage magnifies both the gains and the losses on your investments.
Here’s an example: Say you have $100 and borrow $50 to buy $150 of a stock. If the stock rises 10%, you make $15, or a 15% return on your capital. But, if the stock declines 10%, you lose $15, or a 15% loss.
More importantly, if the stock goes up by 50%, you make 75% return. But, if the stock declines 50%, you’re left with $75. From that, you’ve got to pay back the $50 that you borrowed, leaving you with just $25 for a whopping 75% loss of invested capital. So, as a new investor, make sure you don’t get lured by the siren song of margin and its potential for higher returns.
There are other forms of leverage besides borrowing money, such as options, which can limit your downside, but these are complex instruments that you should only use once you have a full grasp of the market.
So, learn to control the amount of capital you risk, and focus as much on capital preservation as you would on capital gains. In other words, pick investments where your downside is minimal.
Investing cash you can’t afford to lose
Studies have shown that cash put into the market in bulk rather than incrementally has a better overall return, but this doesn’t mean that you should invest your whole nest-egg at one time. Investing is a long-term business, and staying in business requires having cash on the sidelines for emergencies and opportunities. Sure, cash on the sidelines doesn’t earn any returns, but having all your cash in the market is a risk that even professional investors won’t take.
If you don’t have a lot of free cash beyond your emergency cash reserve, simply stay away from the market. Putting all your money on the line makes you emotionally vulnerable and leads to investing with what is called a behavioral bias handicap, which almost predisposes you to make bad decisions. Therefore, only invest money that you can truly afford to leave in the market for long periods of time.
Whether it’s trying to guess which stock will be the next Apple (AAPL), investing quickly in a hot stock tip, or going all-in on a rumor of earth-shaking earnings, investing on news tips is a terrible move for first-time investors. Remember, you are competing with professional firms that not only get information the second it becomes available but also know how to properly analyze a company’s performance before it announces results.
Rather than following rumors, ideal first investments are companies that you understand and have a personal experience dealing with. As good as Warren Buffett is, he always invests in what he calls his “circle of competence,” meaning he sticks to what he knows and understands. You should do the same.
The bottom line
Remember, when you are personally buying stocks in the market, you are competing against large mutual funds and institutional investors that not only do this full-time but also have far more resources and in-depth information than the average person.
Temper your expectations, start small and take measured risks with money you are prepared to lose. Then, after you read up and become more adept at evaluating stocks, start making bigger investments.
While it’s tempting to bet the bank to try and make a quick buck, real money is made by slowly compounding your returns over several decades of disciplined investing.
To find out more, go to www.stevepomeranz.com
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