3 Common Stock Investment Mistakes You’ll Want To Avoid

3 Common Stock Investment Mistakes You’ll Want To Avoid

If you’re new to stock investing, making mistakes along the way will invariably be part of your learning process. However, with a bit of know-how, you can avoid potentially costly blunders.

Here are three common stock investment mistakes you may make as a beginner:

1. Investing without having first saved for an emergency fund

It’s never a good idea to invest everything you have – otherwise, you’ll have to dip into your investments if unexpected expenses pop up. This is a bad idea for a couple of reasons:

  • You may experience capital loss. Stock investing is an exercise in patience. You may have to wait months or years for the value of your stocks to go up. If you sell them off if they have gone down in value or before they have had the chance to mature, you’ll be losing money on your investment.
  • You’ll have to pay the fees again upon reinvestment. If you’re in a cycle of dipping into your investments, reinvesting, then dipping into your investments again, you’ll be unnecessarily paying a lot of brokerage fees every time you reinvest. In contrast, if you have a sufficient emergency fund, there should not be a need to dip into your investments.
  • It takes time to liquidate your investments. While stock investments are considered extremely liquid, you may still need to wait a day or two to sell your stocks to withdraw as cash from your brokerage account. Having funds in a savings account, however, means having access to cash almost immediately.

Before you start investing, build an emergency fund that covers around 3 to 6 months of expenses. You can adjust this amount in accordance with your life circumstances – for instance, if your career prospects are unstable or if you have many financial dependents, you should consider building a bigger emergency fund.

2. Investing in certain stocks because they appear ‘cheap’

Company A
Company B
S$10 per share
S$1 per share

If Company A’s stock is selling at S$10 per share, while Company B’s stock is selling at S$1 per share, which do you think is the cheaper buy?

If you answered Company B based on share price alone, you may be mistaken.

A stock’s share price doesn’t reflect the intrinsic value of a stock – that is, what a stock is really worth, regardless of the price it trades at. This value is determined using the stock’s fundamentals, which refer to measures such as earnings or book value. While different investors have different methods of calculating the intrinsic value of a stock, a few factors they will look for may include:

A low debt to equity (D/E) ratio

The D/E ratio is calculated by dividing a company’s total liabilities by its stockholders’ equity:

A lower D/E ratio usually implies a more financially sound company, as there is low debt load. However, as the D/E can vary depending on the industry, it should only be used to compare companies within the same industry.

An acceptable current ratio

The current ratio is calculated by dividing current assets by current liabilities:

A current ratio of less than 1 indicates that a company’s liabilities are greater than its assets, suggesting that it cannot pay immediate debts with cash. While a ratio above 1 indicates that the company can pay off short-term liabilities with cash, a ratio that is too high could mean that the company is not managing its current assets efficiently. As with the D/E ratio, acceptable current ratios will vary from industry to industry.

Positive earnings per share (EPS) growth

The EPS is calculated by dividing earnings by total shares outstanding (ie, all the shares that are currently held by shareholders):

The EPS represents the portion of a company’s profit that is allocated to each outstanding share of common stock. Value investors generally look for a positive EPS growth rate (represented by a percentage), especially in the past 5 years.

A low price to earnings (P/E) ratio

The P/E is calculated by dividing the price per share by earnings per share:

The PE ratio of a company indicates how much you are paying for S$1 of its earnings. For instance, if a company has a PE ratio of 12, you’d be paying S$12 for each S$1 of its earnings.

A low price/earnings to growth (PEG) ratio

The PEG ratio is calculated by dividing the P/E ratio by the EPS growth rate:

The PEG ratio of a company uses the P/E ratio, but takes into account the company’s growth rate.

A low price to book (P/B) ratio

The P/B ratio is calculated by dividing the price per share by book value per share (which, in turn, is calculated by dividing the book value by total shares outstanding):

 

The P/B ratio compares a stock’s market value to its book value (that is, the measure of all a company’s assets). P/B ratios should be considered in relation to the industry it operates in.

Going back to our illustration: if Company A fares better than Company B in terms of the factors above, then it could be a cheaper buy – even if its shares cost 10 times more.

Value investing

Investors who look for stocks that are trading for less than their “intrinsic values” are called value investors.

3. Attempting to time the market

“Buy low and sell high” isn’t as simple as it seems.

Timing the market can be incredibly hard for amateur and professional investors alike. It’s hard to predict when the market will go up or down. If you wait for the market to go down to invest at the right time, you may be waiting for months, or even years – in the meantime, you’ll lose out on the opportunity to grow your portfolio as the market rises.

It’s also hard to avoid making emotional decisions when timing the market. For example, fear and anxiety invoked by sensationalised headlines may nudge you into prematurely selling your investments, or put you off investing altogether.

Even if you set buy and sell targets based on market movements and stuck to them resolutely, you may still not be able to outperform a buy and hold strategy.

Inclusif Value Fund examined the Straits Times Index (STI) from 1987 to 2017 and simulated 8 investing strategies that were a combination of buy and sell triggers. For example, in the table below, an investor following Plan A would have bought whenever the market dropped 20% after a nine-month peak and sold whenever the market rose 50% from that entry level. These strategies were compared against a buy and hold investing approach.

Image from: straitstimes.com

Out of the 8 strategies, only Plan A outperformed the buy and hold strategy – and only by a small margin. Generally, waiting for a market correction before investing did not outperform the buy-and-hold strategy.

A buy and hold strategy is one that involves buying stocks and holding them for a long period of time, regardless of whether the market moves up or down. The assumption underlying this strategy is that stock prices will generally increase over long periods of time.

If you’re a new investor, consider practising the dollar cost averaging (DCA) method instead – this involves investing a fixed amount on a regular schedule, regardless of the price of the shares. Practising DCA can help reduce the risk of buying shares at the wrong time. By spreading your purchases over time, you’ll be less likely to buy stocks at peak prices, and you’ll get to accumulate more shares when stock prices are low.

The DCA method also helps you sidestep the emotional decision-making involved in investing. Establishing a disciplined investing schedule means that emotions like fear or greed won’t influence when or how much you invest.

Keep learning

If you find yourself guilty of making these mistakes, don’t beat yourself up. Identifying them is the first step to making better investing decisions.

Whether you’re engaging with a professional to help you with your investments, or trying your hand at DIY investing, continue seeking other resources to learn about investing. The best way to avoid costly mistakes – other than through trial and error – is to keep learning.

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