Everyone has the brainpower to make money in stocks. Not everyone has the stomach.
—Peter Lynch, Investment guru and philanthropist
In some ways, investing resembles car maintenance. Most people are content leaving the task to professionals and getting regular checkups by a trusted mechanic. Others like to get their hands dirty and to work on their cars. If you’re like many beginning investors, you probably don’t want to do the heavy lifting required to analyze specific stocks so you’re better off investing in a low-cost index mutual fund or exchange-traded fund (ETF) managed by professionals. However, you eventually may outgrow these investment vehicles and want to start investing in individual securities. Although this can be a laudable endeavor, doing so involves many pitfalls that can lead to big losses.
This chapter focuses on helping to increase your awareness of common stock pitfalls so that you can avoid falling for them. If you want to go the route of carefully analyzing and selecting individual stocks, you need to be aware that by doing so you’re becoming a part-owner of a business. Because the world is changing quickly, businesses need to adapt and prosper or get left behind. Therefore, after buying a stock, you must keep up with news about the business to judge whether it’s successfully adapting to assess whether its stock price is trading at an appropriate price. If you either can’t or are unwilling to put in the required effort, you should avoid owning individual stocks.
A common myth is that investing, especially in stocks, is just like gambling or speculation, but clear distinctions exist between these activities:
When gambling you know exactly how much you can win or lose with a single bet. As an investor, you don’t know how far prices may travel but you expect to earn a fair return in the future for the use of your capital. Although you can lose big on a stock, rarely does a stock’s price go to zero. In the long term, you should be able to make money in the stock market. If you lose in gambling, you lose your entire bet.
Once made, you can’t get out of a bet in gambling, but you can sell an investment or liquidate an asset to exit.
In casino gambling, the house always has the advantage. Although you could beat the house in the short run, you’ll lose over time. In investing, you can improve your chances of being successful by understanding financial markets and instruments and doing your homework.
As a common stock investor, you own part of a company. In a sense, you’re betting on the future of a company. Or if you’re in a stock index fund or ETF, you are betting on an entire sector or country. When gambling such as betting on a horse race, buying a lottery ticket, and playing a slot machine or blackjack, you don’t own part of anything.
Investing increases the overall wealth of the economy as companies compete to create products and services and to improve productivity. By contrast, gambling is a zero-sum game that simply shuffles money between losers and winners without creating any value.
Investing usually has a longer focus and is less risky than gambling. If you ’re acting on a hot tip, blindly picking a stock, and not doing any research, your actions are more like gambling. Unlike investing, actively trading is more like gambling. For instance, if you’re trading for excitement or to win in the short run, then trading and gambling are kindred spirits. Investing shouldn’t be solely about entertainment. If you’re “playing” the stock market and relying on hot tips, rumors, stories, and conjecture as the basis of your decisions, you’re probably not a serious investor and are gambling that you’ll be lucky. Yet, you don’t need to view investing as a chore devoid of enthusiasm. You can enjoy the experience along the way as you strive to reach your financial goals.
Have you ever been enamored by a company or its products and services? The company is well managed, a household name with strong brand recognition and solid fundamentals including growing revenues and earnings. This infatuation doesn’t mean that you should invest in the company’s stock. Yet, investors often fail to distinguish between a great company and a great investment due to an emotional bias. This distinction may seem like a contraction in terms but it’s not.
A problem with “must have” companies is that everyone wants them. Such companies attract investor attention, especially among institutional investors. Consequently, demand pushes up their stock prices to unrealistic levels. Because their prices trade well above their intrinsic or true values, investing in these stocks can be a mistake because their prices are unsustainable. The stock price of great companies can also be taken down by falling markets. Additionally, investors are likely to avoid the stock of a great company in a declining industry. You want to buy stock in solid businesses because you will likely be rewarded over time through share price appreciation, dividends, or share repurchases, but not if the stock is overvalued. In summary, a great company isn’t always a great investment.
Investors often assume that a stock’s true value correlates with its price (market value), but this isn’t always the case. The market can price securities incorrectly. Although a stock appears to be a bargain due to its low price, it may not be a good value. Ultimately, any investment is worth no more and no less than the present value of the discounted cash flows it will produce. Thus, you shouldn’t pay too much for an asset relative to its cash flows.
Intrinsic value is an estimate of a company’s actual or true value whereas market value is a company’s current value as reflected by its stock price. Whereas intrinsic value stems from a firm’s business prospects, market value is determined by the supply and demand of investors buying and selling the stock. Therefore, a stock’s market value may differ substantially from its intrinsic value. A stock’s price decline could result from many factors such as deteriorating fundamentals, changes in management, and increased competition. Psychology and emotions can also affect prices. For example, market values can reflect either positively or negatively investor eagerness to participate in the company’s future. A stock’s market value usually exceeds its intrinsic value if investment demand is strong, leading to possible overvaluation. Yet, weak investment demand can result in undervaluation of a company’s stock. The challenge is to determine whether fundamentals or emotions are driving stock prices to extreme levels. Analysts differ on how to estimate a stock’s intrinsic value.
You’re probably aware of the investing cliché “buy low, sell high.” Buying assets when they’re cheap or undervalued makes common sense. The key to this strategy is to purchase assets or whole markets that have fallen in price but not in value. This simple principle is difficult to execute. A stock selling at a high price could still be a good value in terms of its return prospects. Yet, just because you can buy something at a low price doesn’t mean that it’s a good value or right for your portfolio.
Investors often believe that a stock having declined substantially in price – say from its 52-week high – is a good buy. Yet, lows and highs only become apparent in retrospect. Thus, before buying a stock that simply appears cheap, you should do your homework and evaluate the stock’s outlook. Truly undervalued stocks, such as many out-of-favor stocks, offer opportunities for capital appreciation but are often neglected because of fear of going against the tide.
Savvy investors often use the price-to-earnings (P/E) ratio to assess whether a stock is cheap or expensive. Price alone doesn’t indicate whether a stock is cheap. Conventional wisdom suggests that investors should focus on stocks with low P/E ratios (cheap stocks) based on the rationale that they’re better priced and offer superior upside potential than those with high P/Es (expensive stocks). If a low P/E represents an undervalued or mispriced stock, you can buy it at a bargain price and then profit if the stock’s price increases. Yet, a stock’s P/E ratio doesn’t indicate whether a stock is inherently good or bad. It only reflects the stock’s price relative to its earnings.
A P/E ratio is calculated as a stock’s current share price divided by its earnings per share for a 12-month period. This ratio helps investors determine the stock’s market value as compared to the company’s earnings. For example, a P/E of 15 indicates that investors are willing to pay $15 for every $1 of earnings. Companies with low P/E ratios are usually in more mature industries without much growth potential whereas companies with high P/E ratios are generally in growth industries such as technology with strong growth potential in earnings.
Stocks with low P/E ratios aren’t necessarily a better investment than those with high P/E ratios for several reasons.
P/Es vary substantially among various industries. If you’re comparing the P/E s among companies, you want to conduct this comparison for companies within the same industry or peer group and with similar characteristics. A stock with a high P/E ratio in a high growth category could be just as cheap for its sector as a low P/E stock in an established industry. Additionally, having a portfolio consisting of only low P/E stocks could result in a poorly diversified portfolio.
Stocks with low P/Es could be duds. Low P/Es exist for good reasons. Sometimes a low P/E ratio reflects a lack of growth potential, not mispricing, or that the company is faltering. Such stocks may also represent smaller companies that few investors follow.
High P/Es aren’t necessarily bad. A high P/E reflects the market’s bullish sentiment about the company’s prospects. It generally indicates that investors expect higher earnings. High P/E stocks can still experience large price increases if their fundamentals remain strong or improve. When analyzing a stock, its P/E ratio is only one part of the analysis reflecting a company’s well-being. Although you may be paying a premium for a company’s earnings today, the key issue is whether expected growth merits the premium.
Just as being a successful market timer would be a highly valuable talent, so would being an effective stock picker. A stock pick results from an investor or analyst using a systematic form of analysis to determine whether a stock would be a good investment to add to a portfolio. If you had this ability, you could become incredibly wealthy.
Picking stocks or other securities is like forecasting the future – no foolproof method exists. Research clearly shows that investors generally lose when they trade frequently and attempt to pick winning stocks. Only a small percentage of so-called experts are good stock pickers and some of their success results from luck. Not surprisingly, some professional stock pickers, also known as active managers, are better or luckier than others. Although evidence suggests that some mutual fund managers possess stock-picking skills, you ’re unlikely to be able to identify such managers in advance of their outperformance. Furthermore, uncertainty surrounds whether successful stock pickers in one environment, like a bull or up market, can perform well in other environments. Thus, it is unknown whether those managers can continue to outperform in the future when conditions change. On average, individual investors and actively managed mutual funds underperform their benchmarks on a risk-adjusted, after-tax basis. Stock picking fails because developed markets are relatively efficient, meaning that stocks are usually “priced fairly” given the currently available public information.
If you invest in good actively managed funds, you are unlikely to benefit because fees eat up some or all the additional returns resulting from superior skill. Additionally, more new money from investors flows into these “winning” funds, making them so big that beating the market becomes practically impossible. Thus, savvy investors have steadily moved money out of actively managed mutual funds into index funds and other passive investments such as ETFs. In an actively managed investment fund, a manager or a management team decides where to invest the fund’s money. Actively managed funds also bear greater risks than index funds. In a passively managed fund, the portfolio manager doesn’t select the securities, but tries to mirror the components in an index, such as the S&P 500 Index. As a result, index funds hold investments for longer periods of time and have lower costs than actively managed funds. Thus, you’re better off investing in a global mix of index funds and ETFs than an actively managed fund. By doing so, you reap the benefits of low fees and diversification, while avoiding the stock-picking trap.
If stock picking is such a futile activity, why do the media keep talking about it and individual investors keep doing it? The reasons are simple − investors are suckers for chasing a dream. They desperately want to beat the averages and believe they’re smarter than other investors. But remember, every time you buy a stock, another investor is selling that stock. Who is right in the transaction? Stock pickers must believe that the person on the other side of the transaction is either stupid or misinformed. To identify the misguided investor, they often merely need to look in the mirror. As a novice, instead of trying to time the market or pick stocks, you’re far better off focusing your attention on decisions that have a strong impact on overall performance – namely, determining a proper asset allocation.
Many investors fall into the trap of buying recent winners or chasing today’s hot performers. They’re attracted to top-performing stocks, asset classes, funds, or sectors and want to get in on the action. Basically, such investors are attempting to pick winners for the future by picking the past winners, which is a misguided strategy. High performance attracts investors like moths to a flame. Both generally get burned. Although believing that last year’s big winners are poised for further gains is tempting, the evidence doesn’t support such a belief. For example, research regularly debunks the notion that, net of fees, active fund managers can consistently outperform peers and their benchmarks. In fact, the opposite occurs. According to S&P Global – “Does Past Performance Matter? The Persistence Scorecard,” a stronger likelihood exists that a top-performing fund will become one of the worst performers in a subsequent period than that it will stay a top performer.
Sure, a case can be made for the effects of momentum in the short run. The momentum effect is a market phenomenon by which asset prices follow a trend for a rather long time. Although this effect can mirror economic movements, it can also reveal a growing discrepancy between prices and “fundamental” values. If high performance has lasted for several years, the chances are that the smart money is moving out and dumb money is pouring in. The smart money invested either before the performance cycle started or during its early stages, not after the media has hyped the investment. In fact, evidence shows that only a very small percentage of domestic stock funds remained in the top quartile of performance over three consecutive years. This finding reveals that while some active investors are good in some market environments, they’re not successful in all environments. Sub-par investing performance is largely due to investor behavior including stock-picking, market timing, and performance chasing as well as fees.
Unfortunately, identifying in advance those investments that can beat the market over the long term is exceptionally difficult. The problem is that many factors can affect an investment’s performance including the state of the economy, interest rates, and political issues just to name a few. Short-term performance shouldn’t be the sole criterion for either entering or exiting an investment. Instead of being a prudent strategy, chasing winners is more likely to be a recipe for disaster. You should remind yourself that past performance isn’t necessarily indicative of future results. Your chief concern is what’s likely to happen in the future, not what happened in the past. Over the long run, economic fundamentals drive the markets. Unfortunately, there’s no foolproof way of guessing which stocks or stock funds will outperform in the future. Thus, you might want to save yourself the time and aggravation of trying to do so. You’re far better off maintaining a disciplined approach and long-term perspective rather than chasing performance. Thus, a buy-and-hold strategy is likely to be superior to a performance-chasing strategy for most beginning investors.
Similarly, some investors chase stocks that pay substantially higher dividend yields than others within the same industry or sector. By using much of its cash to pay a quarterly dividend could lead a company to eventually cut its dividends in the future to pay other expenses. Sometimes these higher yields result from a special dividend, which is a one-time distribution of corporate earnings to company shareholders, usually stemming from exceptional profits during a given quarter or period. Some tracking systems fail to filter out this extra dividend from the annualized dividend, which creates an illusion of potential income. Thus, you should look through the windshield, not the rearview mirror to move forward.
A common pitfall that many stock investors face is over-trading, which is excessive buying and selling of stock. Unfortunately, traders may be unaware of this problem until it’s too late. Several reasons help to explain why over-trading occurs. Perhaps the two most frequent causes are failing to have a clear and definite strategy for entering and exiting a position and succumbing to emotions. If left unchecked, over-trading can lead to dire consequences such as a loss of capital and erosion of returns. Whether you’re using a broker or trading on your own, you’re incurring costs with every transaction. By frequently turning over stocks hoping to gain a quick profit or escaping from losing investment, the fees incurred eat into your profitability and reduce your returns. This steady drip, drip, drip while small eventually takes its toll. Too much trading activity can lead to far lower returns than generated by a simple buy-and-hold strategy. Over-trading can also trigger capital gains taxes. Fighting this trading pitfall can involve imposing limits on your trading activity and having the discipline to follow your investment plan.
Wouldn’t you like to have a timing system that takes advantage of the upside and avoids the downside damage of markets? Sure you would. In theory, market timing is a brilliant idea, but in practice, neither professional nor individual investors can consistently and accurately predict short-term market movements. Trying to time the market to achieve short-term gains is risky and rarely a good idea.
Market timing doesn’t yield superior results for most investors unless they happen to be lucky. If anyone could predict the immediate direction of stock prices, that person could become a billionaire. Timing the market assumes that you can foresee when market movements will occur. This belief is a fallacy because neither investors nor traders have a crystal ball. They’re not clairvoyant. Nobody knows where the market is going for sure. No one can precisely predict market tops or bottoms. Furthermore, trying to jump in and out of the market at precisely the right time is likely to result in your missing big up days in the market. Thus, constantly moving your money around can be costly and ill-advised because you end up buying high and selling low, which is exactly the opposite of the Wall Street axiom of “buy low and sell high.”
Many market timing strategies exist but they’re largely ineffective. For example, following one strategy, you’d remain fully invested in stocks when the market is rising but then move to the money market or cash immediately before stock prices start to fall. You’d then move back into stocks at the bottom of the market. For this strategy to work, you’d have to know precisely when to get into and out of the market. You’ve got to be right twice! In short, market timing is a waste of time and hazardous to investment success, especially for novice investors. Although market timing is attractive to traders, it’s particularly unappealing to long-term investors because of its short-term focus.
What’s the alternatives alternative? Instead of attempting to make money using the fast and risky approach of market timing, you could follow a passive buy-and-hold strategy. Using this strategy, you would buy stocks and holds them for a long period without being concerned with short-term price movements and technical indicators. Another strategy is to avoid rushing into the market all at once. For example, if you think that a stock is a good buy, you can “test the waters” by buying some shares now and taking a wait and see attitude before possibly buying additional shares. You can buy additional shares when prices temporarily decline, called “buying the dips,” if you still think the stock is attractive. Oftentimes, no immediate urgency exists to rush into a market. Of course, the possibility exists that the stock could advance leaving you with a foregone profit on the additional shares.
Over time, markets rise and fall, whether justified or not. Knowing when to sell a stock or hold onto it is an important decision facing both investors and traders. Stock investors generally hold investments for the long haul while short-term traders go in and out of the market trying to capture a quick profit. As the great British economist John Maynard Keynes noted, the trader’s task isn’t to calculate an asset’s economic value based on all the information available. It’s simply to determine what some other fool will pay for it. Although there are dangers to selling too quickly, legitimate reasons also exist for selling stock. Let’s first look at the dangers and then turn to the reasons for selling.
Selling a stock too quickly has several drawbacks.
Taxes. A major negative of selling stocks quickly is that you pay taxes on your profits. If you hold a stock for longer than one year, you benefit from the capital gains tax rate, which is generally much lower than the ordinary income tax rate incurred by selling a stock one year or less after purchase.
Commissions and transaction costs. Selling stock using a traditional, commission-based account involves a cost when making a transaction.
Missed opportunities. By selling too early, you could potentially miss out on a big upward move in the future.
Even buy-and-hold investors shouldn’t buy a stock and forget about it for 5 or 10 years. Much can derail a company and its business over time. Here are some appropriate reasons for selling a stock.
Better opportunities. Although nothing may be fundamentally wrong with a company or its stock, more attractive activities may be available that provide a better risk-return tradeoff. On the other hand, changes may occur with a company’s industry, its management, or competition that can reduce a stock’s attractiveness versus other investment opportunities.
Valuation. Overtime, a stock may experience a substantial run up in price making it overvalued given its fundamentals. If the analysis reveals that the potential of future increases doesn’t appear likely, selling the stock now and realizing the gain could be merited.
Faulty investment analysis. Even highly successful investors make mistakes. If you realize that your analysis was faulty, resulting in overestimating a stock’s potential returns or underestimating its risks, then admitting that you were wrong and selling the stock makes sense.
Even highly successful investors and traders suffer disappointments. For example, given day-to-day volatility in the market, a stock’s price may move in a direction opposite of your expectations resulting in a loss. If this loss is small such as a few percent, you shouldn’t get cold feet and quickly dump it. Even healthy, profitable companies experience volatility or dips. You need to critically evaluate whether your initial analysis was faulty or whether the market is still undervaluing the stock. However, you should have an exit point, so you can preserve capital. For example, you may decide to critically reevaluate the stock if its price drops by say 7 to 8%. If your evaluation suggests that the stock is likely to rebound, you may decide to hold onto it at least temporarily. Otherwise, you should sell a stock to avoid even bigger losses. Waiting for your stock to rise again can be a mistake because returning to its previous high may take a long time. You can easily overcome a small loss in a stock, but the big ones can seriously damage your portfolio.
Yet, many investors continue to cling to losing stocks despite the practical tax advantage of selling a stock with a capital loss. Why? Investors dislike admitting that they were wrong and hate to take losses. Thus, they resist selling stocks with losses. Keep in mind, however, that regardless of whether you sell the stock; you still have suffered a loss albeit a paper one. Savvy investors keep their losses small.
You’re probably aware of the common investment strategy of buy low, sell high. This strategy sounds simple enough, but it’s challenging to implement consistently in practice. How do you know when the price has reached a low or high? In practice, you can only identify the extremes in retrospect. Prices are low during market panics and high during market bubbles and thus provide excellent opportunities to buy low and sell high. Yet, the market may continue to move in one direction or the other erasing the previous highs and lows. Many tools are available to help you determine whether prices are low or high, such as moving averages, the business cycle, and sentiment, but these tools aren’t foolproof.
Unfortunately, human nature, through fear and greed, inhibits following a buy low, sell high strategy. Investors are conditioned to follow the crowd, also known as herding. Although the crowd can be right at various points and being in a crowd can feel safe, the crowd is invariably wrong at the extremes. When stock prices are high, many investors don’t want to be left out of the action. Unfortunately, most individual investors don’t hear about an investment from the mainstream media until after it has exhibited strong performance. The stock’s price may already be overvalued. Yet, greed compels them to buy when prices are high based on the belief that prices will continue to rise. When stock prices drop, fear takes over leading them to dump their stocks at low prices. Thus, they end up buying high and selling low. Over time, the market tends to move from fear to greed. In summary, investors often want to hitch a ride onto a shooting-star stock and sell off anything that’s on its way down.
Personal emotions have no place in investing. Savvy investors base their investment decisions on rationality and discipline, not emotions. For long-term investors, market downturns periodically occur are merely speed bumps to be endured over a long investing journey. Instead of viewing these downturns with great alarm, you should view them as opportunities. Thus, the best time to buy stocks is when people are fearful such as when the market has experienced a big decline. The best time to sell is when they’re greedy, which occurs after large bull markets. Yet, investors usually want to swim with the market tide, not against it.
If you’re like most investors, you hate to lose money because it suggests that you made a mistake. Although making mistakes is commonplace in investing, it’s sometimes hard to admit being wrong because it can make you feel inept. When facts challenge beliefs, a natural reaction might be to reject those facts. Consequently, some investors try to camouflage the extent of their losses by averaging down on a losing position. Averaging down refers to buying stock as the price falls in the hopes of getting a bargain. Investors double down instead of facing that they may have made a mistake. For example, assume you initially bought 100 shares of stock at $50 a share. The stock is now selling for $40 a share. Buying 100 more shares at the current market price means that the average price of the 200 shares is $45 a share, instead of the original $50. Although lowering the stock’s average cost gives the illusion that the loss isn’t as great as before, it’s a feeble attempt to coverup a previous error in judgment. Averaging down can be a risky investment strategy because if the stock continues to decline in price, your total losses continue to mount. Savvy investors don’t average down and throw good money after bad.
Why do some investors sometimes engage in this doubling down behavior? One reason is that they’re psychologically inclined to believe they’re correct, even if evidence suggests the contrary. Another reason is what psychologists call cognitive dissonance, which is the psychological stress that someone experiences when simultaneously holding contradictory beliefs, ideas, or values. For instance, your self-concept that you’re smart is threatened by evidence that you did something that wasn’t smart, such as buying a “hot” stock that continues to decline in value. Thus, cognitive dissonance threatens your concept of self-competence. Because it’s uncomfortable, you’re motivated to reduce it by either modifying your self-concept or accepting the evidence. What do you think you would do? Instead of admitting you’re wrong, you’re likely to cling to your initial belief that the stock was a good buy and then buy more at the lower price. However, savvy investors admit when they’re wrong, learn from it, and move on. They realize that success is impossible unless they learn from their mistakes.
Suppose that you have $5,000 to invest. You can buy 5,000 shares of a $1 stock or 100 shares of a $50 stock. Which option seems better? Many investors would select the first option because it seems like a bargain and offers a better opportunity to increase returns. If you’re attracted to penny stocks, which are very small companies whose shares trade below $5, you’re not alone. Many beginners treat low-priced stocks like lottery tickets, expecting to turn a small investment into a fortune. Although this gamble could pay off, it’s unlikely. Penny stocks are cheap for a reason and may not be good investments.
Most penny stocks are high-risk investments with low trading volume, meaning that they lack liquidity. They usually trade over-the-counter instead of on major exchanges such as the New York Stock Exchange. Because of their small capitalization, limited information is available to the public about them. They may also have poor or no track records. Although institutional investors such as mutual funds, pension funds, and insurance companies hold nearly 80% of the largest US companies, they shun penny stocks. A stock is unlikely to experience strong appreciation without institutions fueling their price moves.
These thinly traded stocks are also vulnerable to various fraudulent practices such as pump and dump schemes. Pump and dump is a type of securities fraud involving artificially inflating an owned stock’s price using false and misleading positive statements to sell a cheaply purchased stock at a higher price. Scam artists and dishonest promoters often drive the news about penny stocks because they have a hidden motivation – to inflate the price of worthless shares so they can profit. Since these stocks have such low liquidity, it’s easy for the promoters to inflate their price with some modest buying. But the prices fall just as fast when investors try to sell them. Hence, penny stocks are highly speculative investments ill-suited for novice investors. The love affair with penny stocks can be short lived and end in both heart break and an empty wallet. Thus, instead of fixating on a stock’s price, you should focus on the value of the business in which you’re investing. The savvy investor doesn’t expect too much from penny stocks.
During a bull market, investors should heed the aphorism that “a rising tide lifts all boats.” This phrase, popularized by President John F. Kennedy, suggests that a strong economy benefits businesses and individuals at all levels. A bull market is one characterized by a sustained increase in market share prices. The country’s economy is generally strong and employment levels are high. Not surprisingly, investors want to get in on the action hoping to realize a profit. Thus, if you make money in a bull market, you shouldn’t attribute your success solely to your own brilliant investment decisions. You simply could have been in the right place at the right time. Yet, investors often suffer from self-attribution bias, also called self-serving bias, in which they tend to attribute a successful outcome to their skills but negative outcomes to external factors or bad luck.
In a bull market, the ideal strategy would be to take advantage of rising prices by buying stocks early in the trend and then selling them when they have reached their peak. A problem with this strategy is that determining exactly when the bottom and the peak will occur is practically impossible. In practice, individual investors usually enter a bull market after prices have risen considerably, which limits their profit potential.
A more telling factor of your investing prowess involves your investment performance during a bear market, which is a market in decline. The economy slows down while unemployment rises. In a bear market, investor confidence is shaken as investors become fearful about the market’s prospects. Market sentiment, which refers to the prevailing attitude of investors toward a financial market, is negative. Investors start moving their money out of equities and into safer investments such as fixed-income securities, waiting for a turnaround to occur.
In a bear market, the probability of losses is greater because prices are continually losing value with no end in sight. Even if you decide to invest in stocks with the hope of an upturn, you’re likely to take a loss before any turnaround occurs.
Several strategies are available to try to potentially benefit during a bear market.
Buying defensive stocks. One way to lessen the impact of potential losses is to invest in defensive stocks such as companies in the utility, healthcare, and consumer goods sectors. A defensive stock is a stock issued by companies within a market sector that is less vulnerable to economic downturns due to its non-cyclical nature. Owning defensive stocks in a portfolio enables you to reduce its overall volatility.
Engaging in short selling. Another way to potentially benefit from a bear market is to engage in short selling, which is selling a security that the seller has borrowed. As a short seller, you borrow shares of stock that you don’t own, usually from your broker’s street account, and then sell those shares at the current market price. If the share price declines in the future, you can repurchase those shares of stock at a lower price and then return the borrowed shares to the lender. Be aware that short selling involves much risk. If the price goes up, you lose money, and you could lose big. When you buy a stock, there’s a limit to how much you can lose − 100% of your investment if the price drops to $0. But when you sell short, you can lose even more because there’s no limit to how high the price can go.
You should consider your investing results in the context of an entire market cycle instead of only during a bull or bear market. Why? Evaluating short-term results in a one-sided market can lead to a biased perspective. Because the market operates in cycles, you need to perform in both up and down markets. To determine your investment skill requires examining your portfolio’s performance over the full market cycle relative to an appropriate benchmark. If signs indicate that a bull market appears to be ending, you should make sure that your portfolio can endure the oncoming bear market. When a bear market occurs, you need to get ready for buying opportunities as a bull market emerges.
You might expect that financial experts such as wealth managers and portfolio managers should perform considerably better than non-professional investors. Yet, numerous research studies show that most managers and active mutual funds underperform their benchmarks after adjusting for their costs. As already mentioned, trying to consistently beat the market on a risk-adjusted basis is very difficult. Additionally, no surefire way is available to consistently select outperforming managers in advance. Choosing past winners doesn’t ensure that they’ll be tomorrow’s stars. For example, in professional sports, how many teams that won the Super Bowl or World Series repeat the following year? Not many.
Today, the media are everywhere. You have 24-hour access to financial news and expert opinions by simply using your smartphone or computer and watching TV. Ask yourself, why would anyone provide you with valuable stock tips and investment advice for free or a small fee? Does this make any sense? If the information being provided were valuable, the tipsters or financial talking heads would use this information to make their own profits. Blindly following pundits or market gurus will leave you feeling dumb when you fail to realize the promised return. In fact, most market prognosticators are notoriously inaccurate. Thus, such tips often represent little more than a speculative gamble. If you’re considering acting on a hot tip, you should carefully consider its source, do your homework, or seek out a second opinion from a trusted financial advisor who acts in your best interest.
You also need to be careful buying stocks in companies that have generated considerable interest due to a visionary executive or popular product. In many instances, the media buzz about the company occurs after a large run up in the stock’s price. Although touted as a “sure thing,” it’s not. The media attention is likely to attract retail investors who know little about the company but want to get in on the action so that much bigger investors can bail out and earn a profit. After all, big investors that want out need other investors to buy their shares.
A similar situation occurs with hyped initial public offerings (IPOs) such as with tech stocks. The stock price often shoots up after the offering reflecting investor demand. Because most retail investors can’t initially participate in the IPO, they end up paying higher prices if they want to buy the stock. Given the uncertainty about the stock’s prospects, you’re better off waiting, say six months to a year, to buy the shares of a new publicly traded company so that you can better gauge of the stock’s value.
In summary, you should know your investment friends and enemies. Some false friends, including unscrupulous investment professionals, only pretend to be on your side, when in fact their interests conflict with yours.
Succumbing to any investing pitfalls discussed in this chapter can help separate you from your money and financial security. By avoiding them, your investing path becomes smoother as you develop into a savvy investor. Remember – you want to be a long-term investor, not a short-term trader. Leave the trading to the professionals − even most of them do not do it well. To wrap up, here are some takeaways from the chapter intended especially for novice investors.
Look for solid companies trading at reasonable prices with the intention of holding for the long term.
Focus on value not stock price.
Avoid trying to capture short-term moves by engaging in short-term trading.
Do not attempt to out-smart the markets because you’ll likely fail in the long term.
Avoid self-destructive behaviors such as chasing performance, over-trading, market timing, and averaging down.
Cut your losses. When in doubt, get out.
Consider a buy-and-hold strategy, not buy it and forget it.
Step off the market’s emotional roller coaster.
Avoid buying hype because no investment is a sure thing.