Amateur Stock Investing : Financial Disaster?

by Cameron on August 8, 2011

I Can Do That! : At some point and time, everyone thinks they can score it big with a few stock picks. Everyone thinks they can do better than the professionals. Unfortunately, for some of those professionals, that might be true. The Efficient-Market Hypothesis describes the stock market as efficient. An efficient market means that stocks are appropriately priced based on the current available information and reacts appropriately to new information as it becomes available. If the efficient-market hypothesis holds true, it means that over time, it is extremely rare to consistently outperform the market. For industry professionals, this means that they will eventually have a year where they underperform the market.

Can I Do That? : Maybe you work for a company that you think has a very bright future, even though they haven’t done very well in the past. Maybe a few years ago, you started buying Under Armor. You really liked the products and thought eventually, everyone else would like them too. Maybe a few years ago, you switched from Microsoft to Apple. Maybe you were the first of your friends to start using Netflix instead of the weekly Blockbuster trip. After these types of instances happen a few times, you might start to believe that you are a great stock analyst. It would be hard not to. If you‘d invested in all of these stocks several years ago, you would be able to sell them at a huge profit now. Unfortunately, you weren’t comfortable investing because you thought the professionals knew something you didn’t.

What Do They Know That I Don’t? : Alphas, betas, deltas; sounds like a bunch of Greek letters. Although they are Greek letters, they are also ratios analysts use to evaluate stocks.Analysts use a variety of different ratios to judge a stock, as well as looking a variety of components of a company’s financial statements. It might seem easy to pick one good stock. However, it is too risky to put all of your hopes in one area. Maybe you have a feeling about a stock and decide to invest in it. About that time, there is a large hurricane that takes out one of the company’s primary manufacturing facilities. The loss puts them six months behind on production. By the time the company is running at full capacity, a competitor has introduced their new product that is getting stellar reviews. You’ve lost a large portion of your investment, and the company’s future has been compromised. You thought that your stock was a guarantee so you decided to put your entire investment in it. Market sectors do not always perform as expected. If a large company is hit with punitive damages on a regulatory lawsuit, it may cause your smaller but similar company to lose value. The financial crash from several years ago dragged many other sectors with it. Do you know how the decrease in the price of oil affects your stock? Do you know how political unrest in Cuba could affect your stock? These are all reasons to diversify your portfolio, no matter how much you believe in a stock. Maybe you have always liked the Kodak brand and think it is a great bargain at its current price. If you did the standard evaluations that stock analysts do, you would see that Eastman Kodak has little potential for recurring income in the near future. Financial information shows you that you probably shouldn’t invest in EK, but if you are just going on feeling, you have probably already lost money.

Should I Do That: TD Ameritrade, E*Trade, and other online, do-it-yourself trading facilitators have a large number of users and clients. I am sure that some have made a hefty sum investing on their own. Should you be in charge of choosing securities to invest in? Should you even be investing in securities right now? Should you be shorting those stocks? You are a recent college graduate. You have about $5,000 in your checking account and are considering investing half of that $5000 in securities. Is this a good decision? No. Although it seems like you have some extra money right now, but when investing, you should consider the worst scenario. Pretend the stock does awful and you lose most of your money. At the same time, your transmission on your car messes up. It will cost you about $2,000. You’ve now gone from $5,000 to $500. You are in trouble. This might seem like an unlikely scenario, but it happens more often than you’d think. A good test, for anyone, is to decide if you can afford to completely lose the invested money and still be financially stable. Even if you believe the stock is a sure thing, you never know what can happen in the short term of the stock market. Something like Greece having financial troubles can cause your domestic stock to go down. If you believe that you can afford to lose all of the money you invest and handle emergency financial situations, feel comfortable investing in securities. If not, yet you still invest, be aware that things may go wrong.

Once you have established that you are in a sound financial position and still want to invest in the stock market, decide if you have the time to play the stock market game. First, to determine which stocks to invest in can take a long time. If you have a portfolio of 10 or more stocks, reading and understanding the highlights of the news about the companies you are invested in can take hours. If you have a full-time job and kids, this can be overwhelming.

Finally, are you going to make enough money on your investment for it to be worth your time and effort? If you invested $1000, and have a tremendous 25% return, that’s $250. If you held these stocks for less than a year, you are subject to 15% capital gains taxes, reducing your earnings to about $210. Let’s say you were extremely efficient at reading and understanding the news and what it meant for your companies. You spend two hours per week on stock news for the six months that you are managing your portfolio. You have just spent a total of 48 hours for $210. If you believe making less than $4.50 per hour, you go right ahead. Think about the time that you’ll be spending and the realistic returns that you expect. Is that amount worth your time and effort?

The Answer Is… :  …up to you. Amateur investors have the capability to do very well in the stock market. It might be more risky to invest this way, but it can be very risky to pick a stock analyst without researching the person first. Think it through before you decide to invest at all, much less on your own. If you just have one or two stocks that you’d like to invest in, discuss it with a financial professional to see if there are any obvious flaws in your choices. If not, you can always tell your investment broker that you want to hold those two positions. Another way to judge your picks is to create a mock portfolio. Prove it to yourself that you could earn money in the stock market before you risk real money. The stock market can make you rich, but it can also financially devastate you.

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