Basics of stock market investing: 3 traps to avoid

When you buy low and sell high, investing is easy!

3 stock market investing traps to avoid

If we all knew the exact time to buy and the exact time to sell we’d all be rich and there’d be no point to talking about investing. Few people, if any can know exactly when to buy or sell with any degree of accuracy. Most investors get it completely wrong. Need proof?

If you analyze data from the Investment Company Institute (ICI) and look at the all time highs of the stock market (such as October 2007: Dow 14,000), you’ll see the greatest number of people buying and when you look at some of the lowest points of the market (such as March 2009: Dow 6,600), you’ll see the highest number of people selling. This confirms that most people buy high and sell low. This is the exact opposite of what they should be doing!

Let’s look at three investing traps that leading to buying high and selling low:

Article By Jay

Read more from Jay at Faith-Based Investor.com

1. Following Investment Fads

Since 1990, we’ve seen investing fads come and go. In the 1990s it was technology stocks, followed by real estate, and then it became oil and gold, then emerging market countries like Brazil, Russia, India, and China. Today many flock to any form of green or environmental investing. Investment fads are only in vogue until everybody knows about them. Once they become cocktail party conversation, financial magazine material, or an internet sensation, the fad is as good as dead on arrival.

I remember late in 1999 when I received a call from one of my beloved clients Molly. Molly was in her mid-80s and a very conservative investor. She was wondering if she should sell many of her dividend stock investments and put them into an Internet mutual fund. I asked Molly about her nearly 30% return from the prior year. Was she not happy? She said she had a friend (and everyone has one of these friends) who made over 100% the prior year in an Internet fund. After explaining the risks, and discussing her personal situation, I talked Molly out of investing in the Internet fund. Not that I had a crystal ball or anything, Molly had no place being in the internet.

Normally a fixed income and dividend stock owner, this would have taken her risk level from a 4 all the way to a 10. Molly took my advice and we all know how the Internet story unfolded. I don’t always claim to get it right when it comes to trends or predicting short-term movements in the stock market, but what I can spot are troubled signs that a strategy is headed for disaster. Human nature drives people to invest in fads only after prices have already risen. This means those late to the game are the most apt to get hurt. We only hear about a trend after people have already been successful making it less and less likely that you can follow their success. Instead, you need to figure out how to buy low and sell high. Here’s a hint: investing in fads is not the way.

2. Falling for the Media Madness

Money magazine, Fortune, USA Today, CNBC’s Jim Cramer, Forbes, you name it, they are all there to entertain! Let me repeat this they are all there to entertain. This means sell you something! If you don’t tune in, buy from their advertisers, and continue to frequent them regularly, they go out of business. Bold headlines, irrational advice, entertaining news, sensationalized stories…it must capture your attention.

How poor is the advice from the media? In 2000, Case Western Reserve University conducted a study showing that investors who follow media recommendations lose 3.8% of their money in the following six months after the recommendation. So why do so many people blindly follow the media’s investment advice? Predictions made about sports, weather, and Wall Street make good conversation pieces, but poor investment strategies!

3. Buying the biggest, best known companies

When it comes to investing, many turn to the well known well established institutions. After all they can’t fail? Wait, Enron, Worldcom, Lehman Brothers, and Ginnie Mae to name a few, were giants who became extinct just like enormous dinosaurs. Bigger is not always better! In fact, much of the growth for many companies takes place within the first few years of operation.

One of the biggest advantages of investing in smaller, lesser known companies (small-cap stocks) is the opportunity to outperform many institutional investors. Many mutual funds are limited from buying too many shares of any one company’s outstanding shares. This prevents some mutual funds from giving many small cap stocks any meaningful position in the fund. Because many of these same companies have fewer shares traded, a larger fund also risks bidding up the price of the stock.

Bloomberg provided further proof that the largest companies aren’t always the best. Their publications (as of December 31, 2008) show that 49% of the companies in the S&P 500 (largest, most widely known companies) had lower prices in 2008 than in 2000. In fact Merrill Lynch lost 78% in 2008, AIG lost 97%, Fannie Mae lost 98% Freddie Mac lost 98%, while Wachovia lost 85%. Still not convinced?

From 2000 to 2002 GE lost 53%, from 1999 to 2005 Coca-Cola lost 40% within seven years, from 2000 to 2002 McDonald’s lost 60% in three years, even trusty old Wal-Mart lost 37% from 2000 to 2007 (a 8 year span). These are some of the largest companies in the entire world. If they can lose almost half or more of their value within a relatively short period of time, biggest isn’t always best!

Don’t get me wrong, large company stock has its place in a portfolio. My point is just don’t assume that because you’re buying the biggest and best companies you will profit. As they say “timing is everything”.

In order to truly understand an investment opportunity, much homework is needed. You should evaluate a company’s financial potential by looking at a wide number of financial data available at sites like Morningstar.com, valueline.com, zacks.com, and Yahoo Finance to name a few. Avoiding these three traps will make it much easier for success.

How do I evaluate an investment opportunity?

I avoid mutual funds like the plague. They are too many fees, costs, and few perform well over longer periods of time. Instead, I typically invest in a well diversified portfolio of 20-25 stocks I know very well that line up with my faith and values. Some of the key qualities I look for include companies with:

• Great products and services in an expanding industry
• Strong managers with significant insider ownership
• Strong balance sheets with little or no debt and plenty of cash
• Commitment to returning value to shareholders in ways such as paying a dividend or repurchasing shares
• Strong cash flows, increasing revenues and earnings, improving margins, extremely attractive valuations
• Above all, no involvement in any immoral activities (abortion, pornography, embryonic stem cell research, homosexual activism, etc)