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Friday, December 23, 2016

Five Stock Investing Pitfalls To Avoid

Before you start on any project - whether it be building a house, or travelling to New Zealand on vacation - you need to make a plan. And to make a plan, you need to gather information and consult experts (like an architect or a travel agent).

Investing in stocks to build wealth for the long term is also a 'project'. It requires a lot of effort in learning and consulting experts and planning. Otherwise buying and selling stocks become random activities with little chance of building wealth.

Even after you do your homework and have proper financial and asset allocation plans in place, you need to understand and apply fundamental and technical analysis concepts to decide which stocks to buy, which stocks to sell and appropriate times for buying and selling.

Those are the easy steps to learn and implement. Far tougher is to learn how to control your emotions. To remain impassive and do disciplined investing according to your plans when the stock market is rapidly climbing or falling steeply requires years of experience.

Successful wealth building through stock investments involves planning, regular investing, staying patient and avoiding mistakes. Here are five common pitfalls (mentioned in a recent investopedia.com article) that prevent many small investors from becoming successful:

1. 'Cheap' is not necessarily good value for money - Small investors have a tendency to avoid large-cap stocks because they are 'too expensive'. In any case, mid-cap and small-cap stocks give better returns - don't they? A stock is 'cheap' for two reasons - either the company's operating fundamentals are weak or, it has not yet caught the eye of savvy investors. The trick is to be able to distinguish between the two. Even a fundamentally strong company can trade in the stock market at low valuations for a long time. 

2. A high P/E ratio doesn't mean a stock is overvalued - P/E ratio is an important metric that is often misunderstood. A P/E ratio of 12 doesn't make a stock a better buy than one with a P/E ratio of 42. Why? Companies that require frequent capital expenditure often trade at low valuations. If the average P/E for a sector is 10, and a stock from the sector is trading at a P/E of 12 then it is 'expensive'. But if a company is continuously growing and earnings are keeping pace with growth, then a P/E of 42 can give an excellent investment opportunity.

3. Cutting your winners quickly and letting your losers run - Most small investors should do the exact opposite. Booking profits quickly in a winner and keeping a loser for a long time in the hope of getting back the 'buy' price is a ticket to disaster. Learning how to set a 'stop-loss' will prevent a small loss from becoming a big one. A 'trailing stop-loss' allows you to ride the profits in a winning stock.

4. Averaging when a stock's price is falling - Averaging down is one of the biggest pitfalls that can turn a small loss into a huge one. Why? Because theoretically, a stock's price can become zero. You can go on buying as the price falls, but it can fall even more. If you are really convinced about a company, wait for the stock price to stop falling and then average on the way up.

5. Not being aware of the broader market trend - During a bear phase, big money is made by selling first and then buying back at a lower price later. Such a strategy - called 'short selling' - is not recommended for inexperienced investors. Bear phases eventually come to an end. During bull phases, one can buy at a lower price and sell at a higher price for profit. (Many small investors in mutual funds stop their SIPs during bear phases. That is not recommended.)

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