DIY investing is easier than ever before, thanks to low-cost online brokerage platforms and an unprecedented glut of useful data available online. That’s all great for new investors, but you should still be careful to avoid some common pitfalls if you’re going to dabble in the market. Most DIY investors are unsuccessful, according to repeated quantitative studies by Dalbar that show average individual investors trailing total market returns by two to three percentage points.
DIY investors can fail for a number of reasons, but heeding these four warnings can help avoid those issues that sabotage too many portfolios.
1. Invest, don’t speculate
Investors buy stocks to achieve long-term returns. Those gains come from rising share prices that stem from strong business performance, as well as dividends the company pays out. In contrast, speculators purchase stocks simply because they believe the price will rise in the short term, regardless of the company’s fundamentals. There’s nothing inherently wrong with speculation, but it requires some guesswork and luck, and in my opinion, it’s best left to the quants and technical analysts.
You shouldn’t strive to time markets. Instead, develop and maintain a long-term strategy based on the merits of the companies that you’re buying, and react in a measured way to changing market conditions. Understand your time horizon and risk tolerance, then set up your portfolio accordingly to balance risk and growth. Make sure you’re not in a position where you’re forced to sell shares of a stock that’s only down temporarily, and set yourself up to ride out promising stories until they come to fruition.
2. Remove emotion as much as possible
Greed and fear influence investor decisions too often, but successful strategies overcome those forces completely. It’s easy to let the fear of missing out (FOMO) convince you that a high-flying stock will continue to run and that bull markets never end. Plenty of people felt like geniuses before the Dot-com Bubble burst, and it was because they were piling on trends without any concern for analysis. It’s also easy to panic about paper losses during a bear market, sell your positions, and miss out on the recovery that follows. The Great Financial Crisis spooked a lot of investors who didn’t recover, even though the market did.
The stock market is volatile in the short term, so don’t overreact to natural fluctuations and market cycles. If you own a stock and the investment thesis hasn’t changed, stand by your convictions, even if short-term volatility isn’t cooperating. It can take years for a long-term narrative to come true. If you are going to react emotionally to temporary downturns, then don’t check your account values frequently.
3. Understand what determines a stock’s value
Stocks trade on a secondary market, and the prices there are determined by supply and demand in the short run. Short-term price changes are dictated by the number of shares that are being requested and available for sale at the current market price. Stocks with a lot of momentum can attract investors and send prices higher without anything changing about the company’s operation.
Over the long term, share prices will reflect the cash flows available to shareholders from the business operations. If a company’s valuation veers too far from its fundamentals (sales, profits, free cash flow, or dividends), then the stock price will almost certainly correct at some point. DIY investors shouldn’t necessarily ignore momentum, but long-term strategies shouldn’t be based on temporary forces. Familiarize yourself with common valuation techniques, and think about how a company’s future performance will influence share prices in years to come.
There’s some debate over the extent to which a portfolio should be diversified, but it’s safe to say that DIY investors should embrace portfolio diversification in some manner. Holding too many different stocks dilutes the gains from your best performers, but it also eliminates the risk that any single stock’s failure can sink a portfolio and wipe out years of hard work. It’s good to have conviction in your holdings, but it’s important not to let hubris make you overconfident in any single prediction. It’s impossible to truly know what the future holds, and there’s too much that can change over the long term as companies navigate an evolving global economy. The more smart predictions you make, the less likely you are to suffer from any one of them being derailed by unexpected challenges.
DIY investors who are just starting out should consider using exchange-traded funds (ETFs), which offer inexpensive, liquid, and simple exposure to numerous stocks at once. ETFs can track all varieties of large indexes or niche categories, so a specialized investing strategy can still be executed while achieving diversified allocation. Think about utilizing this alternative to individual stocks.