5 Beginner Stock Trading Mistakes That Stop You From Getting Rich
In the past year, a lot of people replaced sports betting with gambling on the stock market.
Online brokers Charles Schwab, TD Ameritrade, Etrade and Robinhood saw a combined 170% increase in new accounts opened during the first quarter of 2020, as eager new investors saw opportunity after the stock market crashed last March. Investing activity has spiked with each round of stimulus payments.
These amateur traders — especially the Robinhood crowd — have gotten a lot of attention, particularly during January’s infamous GameStop short squeeze.
If you’re a beginning investor using your free time and money to pick stocks, here’s how to do it without going broke.
Trading vs. Investing: Yes, There Is a Difference
Traders and investors both buy stocks in hopes of earning a profit. But the terms aren’t interchangeable. According to Matthew Frankel, certified financial planner at The Motley Fool’s The Ascent, not understanding the difference between the two puts new investors at risk.
“Investing means that you’re buying stocks (or other assets) with the goal of holding them for the long term,” Frankel said. “What many new investors do — moving in and out of stock positions every few days — that’s trading.”
Does that mean you should never pursue trading? Not exactly.
“There’s nothing inherently wrong with trading if you understand that you’re essentially gambling, and therefore aren’t using any money you can’t reasonably afford to lose,” Frankel said.
Stock Trading Tips for Beginners: 5 Mistakes That Could Leave You Broke
You also need three to six months’ worth of living expenses in an emergency fund. It’s essential that you don’t put this money in the stock market. You don’t want to be forced to sell your stocks for a loss because you need cash in a crisis.
If you can truly afford the risk, follow these stock trading tips — and avoid these mistakes.
Mistake #1: Investing in a Company That Just Filed Bankruptcy
Buying stock in a bankrupt company may seem like the chance to score a big-name bargain. Hertz share prices crashed to 56 cents after it filed for Chapter 11 bankruptcy protection in May 2020. Traders rushed in to scoop up what looked like a big-name bargain. By June 8, it was trading at $5.53 per share. Then prices tumbled again. As of this writing on March 31, 2021, shares were priced at $1.72.
Companies declare bankruptcy because they have an unmanageable amount of debt. In bankruptcy court, creditors and bondholders are paid in full before shareholders get a single penny.
“It might seem like a smart idea to speculate on bankrupt companies trading for just pennies on the dollar, but this is a sucker’s investment,” Frankel said. “In virtually all cases, shareholders are left with nothing when bankruptcy proceedings are done, even if the company continues to operate.”
Sure, many traders don’t plan to stick with the stock for the long haul; they just want a quick profit. But a post-bankruptcy rally is often short lived, and you never know when it will flip.
Also avoid investing in penny stocks. Sure, they look dirt cheap, but they’re typically cheap for a reason.
Stock trading tip: If you want to buy cheap stocks, fractional shares are a better option than buying shares of a bankrupt company or penny stocks.
Mistake #2: Buying the Stock Everyone Is Talking About
If you’re making investment decisions based on the latest headlines, you’re too late.
“One common costly mistake is to make buy-and-sell decisions based on price movements that have already happened,” said Brandon Renfro, CFP and assistant professor of finance at East Texas Baptist University. “Seeing a stock climb 10% overnight, for example, is exciting, but if you use that as the reason to buy today you are simply paying 10% more for the stock. A stock’s value to you is what it will earn in the future, not the past.”
Stock trading tip: If you’re buying the same stock everyone else is, be prepared to hold onto it for the long haul. After a stock’s prices skyrocket, a dip — known in market parlance as a correction — often follows, so only invest if you see long-term value.
Mistake #3: Chasing Bigger Profits Using Margin
When you set up a margin account, you can borrow up to 50% of a stock’s value. The 50% you own is your collateral, while the remainder is essentially a line of credit you can use to buy stocks. And of course you pay interest on that loan.
It sounds great because it lets you buy more stocks with less money up front. But when it goes badly, it intensifies your losses.
“Margin is an easy way for inexperienced investors to get wiped out,” Frankel said. “Think of it this way: If you invest $1,000 in a stock and it loses 50% of its value, you can take your $500 and walk away. On the other hand, if you had used $1,000 of your own money and $1,000 in margin, you’d be left with nothing.”
Stock trading tip: Stay away from using margin if you’re new to trading.
Mistake #4: Thinking Your Portfolio Is Diverse Because You Own a Bunch of Different Stocks
You probably know that it’s unwise to invest all your money in a single stock or two. But even if you own stock in dozens of companies, your investments may not have the diversified portfolio you think you do.
“Beginners often fail to properly diversify as well, often because they misunderstand what diversification really means,” Renfro said. “Diversification is more than just buying shares of different companies. Diversification requires buying shares in companies that respond differently to economic fluctuations and have different specific risks.”
The performance of a coffee chain and big-box retailer may not seem like they’re related. But both depend on people having disposable cash. They tend to be in the same malls and shopping centers (with some big retailers even having coffee shops inside their stores) so if one loses customers, it’s likely the other will as well.
To avoid major losses, it’s essential to pick stocks not just across different companies but across a broad mix of industries.
Stock trading tip: A better way to diversify your portfolio is to buy exchange-traded funds instead of individual stocks.
Mistake #5: Trading Too Frequently
You probably don’t want to hear this if trading stocks is your hobby, but frequent trading is often a losing bet in the long run. You risk making emotional decisions based on what the market is doing on a given day. That can lead you to buy high and sell low, which is the opposite of what any investor wants.
“The best way to get started with stock trading apps is to gradually build a portfolio of great businesses, and then hang on to them for as long as they remain great businesses,” Frankel said. “Sure, trading in and out of stock positions is certainly more exciting. But most people who have built serious wealth in the stock market didn’t do it by short-term trading. Good old fashioned buy-and-hold investing remains the most surefire way to make money in stocks.”
Stock trading tip: By holding onto an investment for a year or more, you pay less in taxes because when you sell, your profit is taxed at long-term capital gains rates of 0%, 15% or 20%. If you sell before a year, the profit is considered regular income, which is taxed at higher rates.
Robin Hartill is a certified financial planner and a senior writer at The Penny Hoarder. She writes the Dear Penny personal finance advice column. Send your tricky money questions to [email protected]