A dozen sins that stock investors should avoid

Dollars & Sense

August 18, 2002|By Pat Dorsey | Pat Dorsey,MORNINGSTAR.COM

I've been receiving a lot of e-mail lately from folks asking, "Is now a good time to get back into the market?" Because a lot of these individuals appear to be novice investors (one asked me whether 100 shares was "too much" of a stock), I thought I'd compile a list of a dozen sins that should be avoided by anyone investing in stocks.

Although some of these may sound pretty basic, avoiding mistakes is half the battle when it comes to successful stock investing. You'll be amazed at how much your investment performance will improve if you follow the financial version of the Hippocratic oath: "First, do no harm."

1. Don't short stocks. Yes, there are professional investors who make money doing this for a living. But that's precisely the point - they do it for a living, and they have the capital to back up the inevitable margin call if they make their bearish bet too soon. Remember, when you short a stock, you're borrowing the shares, which means that you're liable for unlimited losses if the shares keep skyrocketing. Folks who shorted Yahoo (YHOO) at $50 in 1998 are happy now, but they had to ante up some serious money in 1999 as the shares rose to four times that level. Who needs ulcers like that?

2. Don't buy concept stocks. As much as we'd all like to think that the road to riches is as simple as buying the next Microsoft (MSFT), the harsh reality is that most speculative companies wind up failing miserably. (Trivia stat: Over time, emerging growth stocks have had the lowest return of just about any investment class.) Buying a small company with a revolutionary idea or product is like buying a lottery ticket: fun and exciting, but not a great way to pay for your kids' college tuition.

3. Don't trade too much. One of the keys to successful investing is treating your stock as pieces of a business, rather than "little wiggly things with charts attached to them," as Warren Buffett would say. If you trade a lot, you're focusing on what doesn't matter (how much GizmoTron shares are moving from day to day) rather than on what really does matter (whether GizmoTron is going to be successful in launching Gizmo 2.0).

Moreover, frequent trading drives up your portfolio's overall transaction costs, which is a sure route to poor performance. If you don't believe me, check the research of Professor Terrance Odean at the University of California at Berkeley. He studied thousands of individual-investor brokerage accounts and found that the rapid traders did much worse than their slowpoke brethren.

4. Don't try to make a quick buck. No one - not chartists, not Warren Buffett, not even those investment newsletters that keep spamming you - knows what stock prices will do in the short run. Therefore, never buy companies because you're expecting "positive news flow" or some short-term development that'll pump up the stock price. If you can't imagine what the company will look like in three to five years, and you don't intend on holding it that long, don't buy it in the first place.

5. Don't bet big on a single stock or industry. The world has this nasty habit of changing without notice, and what looks like a cinch today could be headlining the scandal sheets tomorrow. No matter how much research you do, the unforeseen is always out there. So control your risk by not putting too large a portion of your assets in any single place.

6. Don't fall in love. It doesn't matter how large your gain or loss, how charming the chief executive officer or how many rationalizations you can come up with for hanging on - if a company's financial performance is deteriorating in a big way, you need to think about selling the stock. The day you buy a stock, write down the reason you bought it. When things start looking ugly, pull out your reason, and if the original investment thesis doesn't hold, it may be time to end the relationship.

7. Don't ignore valuation. At the wrong price, even the greatest company is a poor investment. You could have bought steady-Eddie Coca-Cola (KO) a few years ago and still be underwater, after all. The key thing is to remember that successful stock-picking has two parts: Find a great company and pay a reasonable price. You've got to pay attention to both.

8. Don't buy just because the price went down. Cheap stocks can always get cheaper, and yes, stocks really can go to zero.

9. Don't buy IPOs. Ninety percent of initial public offerings are overpriced. After all, why would a company go public unless it thought it was getting a high price? Over the long haul, IPOs have significantly underperformed similar stocks, and there's just no reason to pay any attention to them - until they've been on the market for a little while and dropped about 50 percent, of course. Then, you can often find some good bargains. (Exceptions to the "no-IPO" rule are spin-offs, which are often underpriced, and forced sales, like CIT Group (CIT), which are sold cheap because the parent has to raise capital and can't wait.)

10. Don't be impulsive. No matter how great a bargain something might appear, don't buy without doing your homework first. At an absolute minimum, this means reading the previous year's 10-K filing.

11. Don't listen to stock tips. Any stock you read about in a magazine, newspaper or this column deserves further investigation before you commit your money. Why? First of all, it's your money, and second, how are you going to know when to sell?

12. Don't ignore your stocks. Buy and hold doesn't mean buy and forget, which is what some pundits would have you think. Keep up on your stocks by checking the news once in a while, and always read the annual report.

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