The Investor Buys their First Stock
The Beginner Stock Investor
The beginner stock investor has just bought their first stock. This is an exciting time for the beginner stock investor and their hopes and dreams of a wealthy future look set to be fulfilled.
While the beginner stock investor may have come to the realization that stock prices do bounce around, they are firmly under the belief that from now on that the stock price will simply go straight up and never look back.
After a period of months, the stock price is actually below their purchase price and looks set to remain there. They now begin to wonder what's gone wrong. After all, the stock price was supposed to go up and not down!
This scenario catches out most aspiring beginner stock investors and comes about from simply having no understanding of how the stock market functions.
Inevitably, a lot of these beginners decide to sell their supposedly underperforming stocks only to find later on that the stock price is now significantly higher than the original price they paid for it. Thus they managed to turn a profitable investment into a losing one. This is a trait exhibited by most beginner stock investors.
So what went wrong?
Actually nothing went wrong with the stock as it was merely doing what stock prices do and that is fluctuate around considerably.
Just because the investor has now bought the stock, does not mean that these price fluctuations will now stop. They won't!
What went wrong was that the beginner stock investor needed to come to the realization that once they buy, the stock's price may spend a fair amount of time below their purchase price. Usually this is months and maybe years. While this is emotionally and financially uncomfortable, it is a part of stock investing and there are tactics that reduce its impact (such as avoiding buying overpriced stocks).
A bear market will see stock prices well below the investor's purchase price and it can take years (2 years or more) until stock prices come back above their purchase price. That's why investing is a long-term approach!
In 20 years time, the stocks price might be 5 or even 10 times higher than what the stock investor paid for it, but in the short-term prices will most likely spend a fair amount of time below their entry price.
The beginner stock investor needs to ascertain whether anything fundamentally has changed with the stock since they bought it. More often than not, the answer is no.
The only thing that has changed is that the stock's price is now below the investor's purchase price.
If the investor had not yet bought the stock, they would just buy the stock at this price thinking it was a good investment, but because they have already bought at the higher price and the price dropped, many stock investors will now considerer this stock as a bad investment and decide to sell it (Ironically, when other stock investors decide to buy it).
Can the stock investor see the apparent contradiction - the same stock cannot be a good and a bad investment at the same time?
Selling stocks below their purchase price for no other reason than the stock's price is below the purchase price is a great way to lose money.
There are genuine reasons for selling a stock, but selling just because the price is below the stock investor's purchase price is not one of them.
Genuine reasons for selling a stock include but are not limited to;
Reasons for selling a stock:
- The stock is becoming excessively overvalued and at a high risk of its price correcting.
- The stock is over-priced and there are better valued stocks to invest in.
- The stock is becoming fundamentally unsound and the stock investor has better prospects with another stock.
- The stock's growth rate is peaking or has stopped and there are other stocks with better growth prospects.
- The stock investor uses a price stop to sell the stock with the intention of repurchasing the stock either at a lower price or if the stock's price regains strength.
Beginner stock investors tend to be extremely impatient and patience is one of the skills that successful stock investors have developed.
Once the stock investor learns how the stock market functions, patience tends to develop naturally and is reinforced with experience.
Stock Investment Scams
Traps that stock investors need to be aware off
There are numerous stock investment scams around which are primarily designed to profit at the expense of the stock investor.
The victims of these scams are typically beginner and inexperienced investors who are lured by the promise of quick easy money.
Some scams are not technically illegal but are illegitimate, while others are just outright fraud.
Scams can take on many different forms and new scams replace old ones. Some scams are in vogue for a while and then disappear only to return some years later.
Beginner and inexperienced investors have no idea that they have been conned until it's too late and some are never even aware that they were a victim.
Some of the more common scams aimed at stock investors are;
The Fake Investment Adviser
The con artist acts as an investment adviser and sells stocks directly to the investor. The investor has faith in the "supposedly" investment adviser as they are considered a professional.
The stocks are legitimate companies listed on an exchange. The stock investor hands the fake investment adviser money in exchange for the stock and as far as the stock investor is concerned, they are a stockholder on the company's books and the investor is given a stock certificate as proof of ownership.
The problem is that the fake investment adviser actually handed the investor a forged fake stock certificate and the investor does not own any shares in that company. If the investor wants to sell their "fake" stockholding, the fake investment adviser convinces the investor not too sell, but to buy more stock as it is now a good value buy.
The Fake Mutual Fund Company
These con artists convince an investor to invest in their "fake" mutual fund. Typically they will have setup fake past performances that are outstanding. The investor is lured by the impressive historical returns and just cannot pass up the opportunity.
The problem with this fake fund is that it does not own any stocks and there is no portfolio.
While the investor actually receives a regular distribution payment from the fake fund, the return they are receiving as cash payments actually comes from the capital that the fake fund obtained from the next investor who decided to invest in the fake fund. Thus the returns are nothing more than a portion of the next investor's capital.
These con artists are similar to the fake investment advisor, except they do not try to obtain the trust of the stock investor over a period of time.
Instead they use a variety of cold calling tactics which traditionally involved ringing potential stock investors on the telephone and trying to sell them the stocks directly.
With the surge in the popularity of the internet, spam E-mails are becoming common nowadays.
Their sales tactics are typically high-pressure and the stocks they try to sell are usually very small companies. They will make outrageous claims about how much money the stock investor will make and that it is a sure thing with high returns and next to no risk.
Buying stock is made easy as there is no need for a stock brokerage account and they may even offer the stock with no brokerage costs just to sweeten the deal.
At best they are unlicensed stock brokers, but more usually the stock investor never receives ownership of the stock. Some boiler rooms will even try to sell investors shares in companies that do not even exist.
Pump and Dump
The pump and dump scam occurs when an unscrupulous investor relentlessly self-promotes a stock which is usually a small-cap stock with no or little future prospects.
The unscrupulous investor actually buys the stock and promotes the stock as being a sure thing with enormous prospects for future growth, usually with false information and fictitious earnings estimates.
The actual promotion is conducted through internet chat rooms and spam E-mails sent out to potential stock investors whose E-mail addresses are typically obtained from lists that can be purchased.
The purpose of this promoting is to drum up interest from unwitting stock investors who are lured by the promise of making a fortune.
Their buying pressure drives up the price of this mostly useless stock were the unscrupulous investor then sells their stock at these elevated prices.
Once the unscrupulous investor has sold their stock, they cease their promotional activities and the stock price then typically falls back to where it was leaving these unwitting stock investors with a loss.
Investment advisors and stock brokers must be registered with the U.S. Securities and Investment Commission (SEC). The role of the SEC is to ensure that stock investors are treated fairly by investment professionals.
There is a danger in buying stocks though an investment advisor or a stock broker who is not registered.
Stock investors should only open a brokerage account with a registered stock broker. This ensures that any stocks bought and paid for are actually transferred across to the stock investor. This proof of stock ownership can be in the form of physical certificate, broker firm registration or direct registration.
An investor who buys stocks through an investment advisor needs to check with the SEC to make sure they are registered.
The investor can also check whether a mutual fund is registered with the SEC.
Registered investment professionals are not permitted by the SEC to make exaggerated claims about the performance of a stock or fund.
Basically if it sounds too good to be true then it probably is a scam.
Unfortunately with the pump and dump scam there is no way for the SEC to regulate it as these unscrupulous investors are most likely private investors.
The only way for the stock investor to safe guard themselves is to be wary of spam E-mails they may receive and to be cautious about any information they may obtain from chat rooms such as forums.
The Stock Market Lottery Ticket
Now that you have bought your stock, let's hope you win
The stock market uses an obscure term to describe its function, namely "stock" which is actually an accounting term derived from "trading stock" which is simply the products a business sells.
A more accurate and informative description for buying stocks is buying "Company Shares".
Buying a Share of the company is what the stock investor is actually buying. This means the stock investor is now a part owner of an actual business which sells a product or provides a service.
For many stock investors (particular beginner investors), buying a stock is treated more like buying a lottery ticket. They simply buy their stock lottery ticket and hope they win.
This mentality explains why stock prices can become so excessively high relative to what the business is worth.
These stock investors are often surprised to learn that the stock they bought was an actual business and that they are a part owner of it.
The main attraction these stock investors have towards a particular stock is with the stock's price history.
Stocks that have significantly increased in price over a period of time (such as the last year or two) are seen as attractive investments as the annual returns have been spectacular.
After all, no stock investor wants to miss out on these returns and the seemly consistent stock price appreciation provides confidence that these returns should continue unabated into the future.
These stock investors, having no idea of what they have bought, make no connection with the stock's relentless price increase and the worth of the company. The only thing that is important to them is that the stock's price history has shown impressive capital returns.
They will typically find any excuse to justify why the stock's price should continue to increase.
Investors have a tendency of buying a rising
stock price rather than a growing business
In the world of consumer spending, the consumer is generally reluctant to pay more for purchases than what they think they are worth.
Given the chance, the consumer will aggressively pursue any bargains they may come across.
However, when these same consumers become involved with the stock market, any logic they exhibited with their consumer spending is completely dismissed and replaced with an irrational gambling mentality.
These irrational thought processes are best illustrated with an example.
The Increasing Stock Price
A company that is valued at $10 has been increasing in price over the last six months and is currently trading at $20.
For many stock investors, they will see the stock price increase as a sign that this is a great investment and so they buy some stock for themselves.
Their own buying adds to the demand for the stock and while demand exceeds supply, the stock's price will continue to increase.
Some stock investors were hesitant and did not buy the stock at $20. The stock's price after another six months has now reached $30. These stock investors who missed out are now convinced that the stock's price is just going to keep increasing and now purchase the stock.
After all, they don't want to miss out on any more of the profits.
For other investors who bought another stock at say $20 and saw their stock plunge down to $10, they are skeptical of this stock trading at $30. They don't what to risk another loss.
The stock's price after another six months reaches $50. The skeptical stock investors who had the losses from another stock see this stock which is now at $50 and conclude that this stock must be a good investment as the price just keeps going up. They decide to buy this stock at $50.
The stock investors who bought at $20 or $30 are now regretting that they did not buy more. They are convinced that this is a fantastic investment and do not want to miss out on further gains, so they buy more stock at $50.
The buying pressure from these stock investors keeps the demand up for the stock, which keeps driving the stock's price higher. This will continue until some event causes the stockholders to decide to sellout. When this occurs and sooner or later it will with an overvalued stock, the supply then exceeds demand and the stock's price tumbles.
The event can be anything, but inevitably it is something that causes the rationally thinking stockholders to decide to sell their stock at these overly inflated prices before prices drop back to what the stock is worth.
Ironically, it is actually the selling pressure from these rationally thinking stockholders that fuels the increased supply which now exceeds demand.
These rationally thinking stockholders are scrambling to lock in their impressive capital gains before stock prices drop, as they typically bought when stock prices were around what the stock was worth.
As the example stock was worth $10, the lottery ticket investors who bought at $20 or $30 enjoyed some capital gains for a while, but after the stock' price tumbled they are now faced with a significant capital loss. For the lottery ticket investors who bought stock at $50, they did not even enjoy any gains and are just faced with their significant capital losses.
Many of these lottery ticket investors will sell their stock at these now low stock prices just to make the psychological pain of enduring a relentless price decline go away.
Their irrational logic now dictates that the stock's price will just keep falling with no bottom in sight.
These lottery ticket investors with their irrational logic are an important component of the stock market as they are the stock investors who provide the demand to drive stock prices way above their valuation, which provides the savvy stock investor with opportunities to profit from.
Indeed many speculative traders participate in these relentless uptrends.
The primary difference is these speculative traders are fully aware that at these prices, the stock is a bad investment. They only buy the stock to sell it shortly afterwards for a small capital gain, rather than holding the stock as an investment.
The Focus on either Risk or Reward
Beginners tend to concentrate all of their effort on one area only
Investors New to the Stock Market
Beginner and inexperienced stock investors tend to fall into two distinct categories. They focus heavily on the risks and ignore the rewards, or they focus heavily on the rewards and ignore the risks
Long-term success in the stock market is achieved by determining the rewards that are available while being aware off and managing the associated risks.
The first concept that stock investors need to clear on is that the most that can be lost on a stock investment is the price paid for that stock.
However, there is no maximum limit to the profit that can be obtained. For example, a stock bought for $20, the investor cannot lose any more than $20 a share, but there is no limit as to how high the stock price can go and the stock price could reach $100 or even $500 a share.
Only Focusing on the Risks
If the stock investor merely focuses on the downside risk, then they are missing the whole point of investing in the stock market and that is the long-term gains that are readily achievable.
Stock investors who focus heavily on the risks are typically concentrating on the short-term fluctuations and market corrections. This leads to the next concept which is time in the markets.
It cannot be stressed enough that investing in the stock market is a long-term process and there will always be short-term fluctuations in the stock's price and there will be more bear markets to come. Long-term means 20 or 30 years, not one or two years.
Over the long-term the stock market increases in line with the long-term growth in the economy and this leads to the next concept.
The stock market does not go up in a straight line. The stock market is best thought of as a roller-coaster ride that is built on an uphill slope.
The roller-coaster has plenty of ups and downs, some of which are quite dramatic which gives the patrons a thrill ride.
The stock market is the same with the ups and downs and some of these are dramatic. But since our stock market roller-coaster ride is built on an uphill, each successive low point on the roller-coaster ride is higher than the preceding low point (These low points are the bottom of bear markets).
Those stock investors who are focusing on the risks are actually focusing on the downward part of the roller-coaster ride without taking into consideration that the roller-coaster actually bottoms out and starts a new upward part of the ride.
Investors need to focus on both
the rewards and the risks
One on the most common traits of stock investors is they buy their stocks near the current top of the roller-coaster ride and when the ride then heads downwards they actually sell their stocks towards the bottom (usually on fear that the roller coaster will never stop going down, which of course is not physically possible).
Buying Over-priced Stocks
Beginner and inexperienced stock investors are notorious for buying over-priced stocks and selling under-priced stocks. This is naturally a good way to lose money and further reinforces their need to overly focus on the risks.
These over-priced stocks are generally continuingly heading upwards and are a magnetic attraction for beginner and inexperienced stock investors who focus heavily on the rewards and ignore the risks.
Their perception is that since the stock has seemingly increased so reliably in price that this will continue unabated into the future. This leads to the next concept.
Stocks that continue to head upwards without a correction are generally becoming increasingly overvalued, especially if the stock's price is increasing at a faster rate than the companies profits are increasing.
These stocks are generally riding the upward part of the roller-coaster ride and stock investors that pay these high prices are also at risk of buying near the current top as the ensuing downward part of the roller-coaster ride will plunge the stock price considerably.
While the stock price will recover somewhat on the next upward run on the roller-coaster ride, most of these stock investors will tend to sell out during the downward part of the ride.
Be aware of the Rewards and the Risks
To be successful and therefore profitable with stock investing requires a balance between the rewards and the risks.
Stock investors need to be aware of both the rewards and the risks.
Simply handing the decision over to a fund manager only removes the decision regarding the individual stocks; it does not remove the decision with respect to their portfolio as this is still subject to the stock market roller-coaster ride.
By applying the basic concepts of stock market investing into their own decision making process, the beginner and inexperienced stock investor will be better equipped to manage their portfolio and avoid the many silly and irrational decisions that plague a lot of investors, whether they buy stocks or funds.
Beginner Stock Traders
A common trap for beginners is to immediately start trading
A buoyant Stock Market with favorable financial press coverage will always attract new comers to the stock market.
These new market participants are full of ambition, with hopes and dreams of making quick and easy money.
They are attracted to the image of "Stock Trading" and are keen and eager to participate immediately.
They have no fear and treat stocks like buying a stock market lottery ticket.
They have no knowledge of the working dynamics of the stock market and due to their impatience will immediately participate in the stock market with their hard earned cash.
They base their trade entries on tips and rumors and they ignore any guidance that suggests they should acquire a sound trading knowledge base before committing any funds to the stock market.
Trading with a False Sense of Security
These beginner stock traders (which can also include stock investors who are enticed by a quick profit) typically enter their trades when market conditions are good and sell their stocks when they show a reasonable profit.
This naturally continues to increase their trading account balance and lulls them into a false sense of security.
These cumulative profits give the beginner stock trader confidence that they are a master of their domain and they have the impression that this buoyant stock market will continue unabated.
After all, their chosen trade entries are reliably producing a profit and as such beginner stock traders see no reason why this should not continue.
This buoyant stock market may continue for some time and the beginner stock trader's confidence is continually increasing.
As such, beginner stock traders have a tendency to continually increase the amount of risk they are taken on, by utilizing a higher percentage of their trading capital and by taken on trades with a higher level of risk.
Then all of a sudden the beginner stock trader, who by now is used to the idea that stock prices just go up, find themselves in a situation where the unthinkable is happening - Stock prices that had been so reliably increasing are now rapidly declining.
To make things worse, most of their new and recent trades entered are trading well below their entry prices and their losses just keep accumulating.
Stock Traders Losing Money
This leads to a new phenomenon for the beginner stock trader - Losing money.
As such, the beginner stock trader who was used to exiting a large portion of their trades at a profit is now faced with a portfolio of stocks that is continually losing money.
They will typically blame the market for their losses.
Unfortunately for the beginner stock trader, these continuing loses are rapidly eroding the nice profit they had accumulated. This naturally causes some anxiety and the beginner stock trader starts to wonder what they are doing wrong.
After all, it was working fine but not anymore and their confidence is now shaken.
So what is the problem? Simply put, beginner stock traders have a lot of enthusiasm but absolutely no knowledge of how the Stock Market works.
A little knowledge can be dangerous, especially in the stock market and trading is not as easy as it looks.
Profitable stock traders are educated with the working dynamics of the stock market and adjust their trading to suit current market conditions.
So what is the solution? Basically beginner stock traders need to educate themselves with the working dynamics of the stock market.
Trading without a sound knowledge of trade management techniques is a recipe for financial disaster.
Simply taking trade entries based on rumors and tips is more like gambling as there is no rational basis for the trade entry and even worse there is no management of their positions especially with a losing trade.