Pitfalls to avoid when buying stocks
Question: I have been trading stocks for over a year now but I don’t seem to be making money because it’s either I always buy the wrong stocks or I trade at the wrong prices. What should I do?—Jim by e-mail
Answer: There are always risks involved when you invest in the stock market. It is like going to a carnival where you experience the ups and downs of a roller coaster ride without clear direction of where you are really heading. There is no perfect investment system that will guarantee that you will beat the market at all times. Your task is to manage your risk and control the direction in your favor. Stock investing can be fun and exciting but when it is not managed well, it could be disastrous to you both financially and emotionally.
When you invest, try to manage your risks by avoiding the following pitfalls:
1.) Buying on rumors and tips
You tend to use more of your emotions rather than logic when you buy a stock based on pure speculations. Normally, your stockbroker will make suggestions to you and tell you all sorts of stories that he heard from another broker who, in turn, heard those stories from another source. Market reacts on rumors easily so a stock price can go up fast and excite everyone but it can plummet faster the next day as soon as the news is proven false. There is nothing wrong with listening to rumors, but always check the fundamentals of the stock. Review the past disclosures of the company and try to relate the rumor with facts to determine if there was any basis. If there is, assess the implications on the company and how this will affect the stock price in the future.
2.) Relying on stockbroker’s recommendations
A number of stockbrokers in the market keep a team of research analysts who follow companies and make recommendations for their clients. Your stockbroker may be sending you regular research reports on what stocks to buy or sell. Sometimes, they provide target prices as guide. This is actually good information as the research has already been done by other people for you, but you should not rely on their recommendation blindly. You have to remember that what your stockbroker is suggesting to you is his opinion. You may disagree by having a different opinion. You can use the research report to study it, verify its assumptions and make your own decision.
3.) Trading on short-term plays too much
The idea of buying and selling stocks on the same day for profit is very tempting, especially if the market is highly volatile. When you do this successfully, you are not obligated to pay your broker on settlement date. Instead, it will be your broker who will hand you the check. Yes, this is nice but this doesn’t happen every day. If you are going to play the stock market with the objective of making money on intraday trading or at least within the settlement period for small gains, you will most likely end up losing more than you can imagine. Why? Because the more you trade, the more transaction costs you are going to incur. This is not to mention the losses that you may have to absorb when you close your position. You may make some money in some trades, but the cumulative trading costs will ultimately offset all your gains and possibly more.
4.) Borrowing money to invest
Make sure that the money you invest in the stock market is the money that you can afford to lose. Do not use your lifetime savings that you intend to use in, for example, paying for your brother’s tuition fee next year or the airfare for your family travel on Christmas. When you trade on a margin facility provided to you by your stockbroker, you are essentially borrowing money. For example, the stocks you bought and paid for has market value of P10,000. If you trade on margin, you can borrow up to P10,000 or more to buy the same stock without cash out from your side. Imagine for every 10 percent increase in stock price, your return on investment will be 20 percent. Fantastic, right? This is good if the stock price is going up because you can leverage on borrowed money. But if the stock price goes down, your losses will also double. The risk is if your stock price plummets by 50 percent, you would have wiped out all your capital and possibly more if the fall continues.
5.) Failing to understand the stock
When you buy a stock, treat it as if you were buying the company. Try to understand what kind of business the company is into and assess its business model. How does the company make money? How is the capacity of the company to sustain cash flows? Have you tried their products and services? Do you trust the people behind the company? If the company is too complicated for you to understand, change it and look for simpler business model.
As you manage your risk, you should be able to focus and apply a more disciplined approach in investing stocks. Never make the mistake of rushing to invest for the sake of getting into the play. Be patient, do your research and monitor the stock price for buying opportunities.
Henry Ong, RFP is a registered financial planner of RFP Philippines. You can e-mail him for comments and questions at [email protected]. To know more about how to become registered financial planner, visit www.rfp.ph or inquire at [email protected].
