Capital investment requires extensive knowledge of the market. Most beginner investors often make the mistake of buying a stock because they like the company name or product without doing adequate research while they allow their emotions to cloud their judgment. Capital investment requires you to keep your emotion in check and be realistic with yourself.
It will be smart for a new investor to be simple with his investment. You should only invest in companies that you understand their products or services. More importantly, never buy a complex instrument or a stock you do not understand.
Although capital investment is no rocket science, it, however, requires you to understand some of the risks associated with capital market investment. We will discuss some pitfalls new investor should be wary of.
Risk of Buying an Unhealthy Company
It is smart that you should ascertain the company’s financial health before buying, by doing a fundamental analysis.
Fundamental analysis will require you to check out the company’s balance sheet, income statement and cash flow.
The balance sheet will help you to understand the financial strength and weaknesses of a company, income statement will provide you with a snapshot of the company’s profit and loss while cash flow demonstrates how a company has spent and received money.
A company with high debt to equity ratio (huge debt compared to value) could be considered unhealthy for investment. On the other hand, a company with a low debt to equity ratio is considered financially healthy and is more likely to pay dividends.
Dividends are the money or additional shares paid to shareholders or investors by the company from its profit as a way of saying thank you for the ongoing support. Dividends are used to incentivize shareholders to keep holding.
Risk of buying Penny Stock
Penny stocks are high-risk securities with small market capitalization. They have a very low price. They are most times traded for less than £1 in the UK and have a market capitalization of less than £100 million.
The popular sentiment behind buying a penny share is that the small company will grow over time. Penny stocks are highly speculative and sensitive to market news and development which makes them very volatile. They are illiquid which means they cannot easily be sold or exchanged for cash.
Penny stocks are mostly listed on small exchanges and they are likely to be delisted if they are poorly managed. Furthermore, you cannot use penny stock as collateral for a margin loan.
A margin loan is money you borrow from your broker or exchange to buy stock to increase your gain on investment.
Penny stocks are also prone to price manipulation such as pump and dump. The company could go bankrupt which will therefore affect your investment.
Risk of buying Low-Quality Bonds
Bonds are investment securities where you lend money to a company or government for a particular period in exchange for interest payments. Immediately after your bonds reach the maturity period, the company or government will return your money to you.
Bond-rating is used to measure the creditworthiness of a bond. It is a third or independent evaluation of the likelihood a government or company will repay a loan interest and the principal.
Some of the big bond rating agencies include Standard & Poor’s, Moody’s Investors Service, DBRS and Fitch Rating. Bonds are rated as AAA, AA, A, BBB, BB, B etc.
For example, Fitch ratings affirmed the UKs credit worthiness at AA-, so investing in the UK is considered safe. If not properly guided you could go and buy BB rated bonds that carry a high risk of default. AAA and AA rated bonds are the safest.
Although bonds can be a smart way to generate income and it carries low risks compared to stock. Bonds could nevertheless be affected by high-interest rates. Similarly, low-quality bonds could suffer from liquidity which could make it a bit difficult to sell.
Risk of not Diversifying
Diversification is an ideal way to keep your investment portfolio healthy. A portfolio is therefore a group of assets such as stocks, bonds and other financial instruments which you have invested in for-profit or return. Portfolio diversification helps you to limit loss, especially during a downturn.
Portfolio diversification is not just about buying stocks with different names, it entails diversifying between different geographies, industries and different sizes of market capitalizations. According to billionaire investor Ray Dalio, diversification is the most important thing in order to invest well.
A key success to portfolio diversification is to ensure that the assets are not correlated to one another. A significant number of new investors do make the mistake of buying assets that have positive correlation and this often affects the health of their portfolio.
For instance, if you have shares in Land Rover, Jaguar, Mini and Aston Martin, these all have correlations and are in the same industry (Automobile). Thereby, the in event of a downturn, you will be exposed to maximum risk.
Your investment should cut across different industries like Real Estate, Automobiles, and Technology. You can also consider different asset classes apart from stock such as bonds and mutual funds.
With the prospect of another recession, new investors will have to buy stocks with strong fundamentals. Otherwise, their investment could be eroded by a possible market downturn.
Risk of buying Meme Stocks
Meme stocks are stocks that gained or are influenced by huge social media traction. They are often overvalued compared to their utility and fundamentals. When you see a stock with a high price but its history shows it has been having low prices, be careful it might be a meme stock. Meme stocks are like Ponzi schemes, a few benefit before it crashes.
A prominent example of a meme stock is GameStop which attracted a large following on Reddit a social media platform. Groups of Reddit users ganged up and bought large quantities of GameStop and this caused the price to skyrocket to new highs.
Although those who invested in GameStop and AMC at the early stage made earnings from them then these Reddit users suddenly sold their holdings in one fell swoop, and the share price crashed taking casualties along with it.
Meme stocks are however risky, especially for new investors. Meme stock will eventually plummet significantly because they are overvalued and this can cause you a huge loss of capital.
Guidance for New Investors
Consider Exchanged Traded Funds (ETFs)
ETF is a basket of mixed securities such as stocks, bonds and commodities. It offers smart portfolio diversification and exposure to a range of markets.
It could also track the performance of indices. For instance, iShare FTSE 250 ETF tracks 250 of the largest middle capitalization companies in the UK. When you buy its shares, you own shares in all the 250 companies it tracks. This is good for diversification and ideal if you are just starting your investment journey.
Some of the big names on the iShares FTSE 250 ETF include:
- Easy Jet
- Unite Group
- Centrica ORD
- Tritax big box REIT
- Unite group REIT
As can be seen above, Easy Jet is in the transportation industry, Tritax is real estate, etc. so there’s diversification. ETF are a ready-made basket of assets and will save you the stress of analyzing individual financial statements of companies.
Avoid Speculation Using Derivatives
A derivative is a contract between two or more people. It is a financial product that enables traders to speculate on the price movements of an asset without purchasing the asset themselves.
One of the most prominent derivative products is Contract for Difference (CFD). When you trade CFDs, it means you are speculating on the price difference of the underlying asset from when you open a position to the time it is closed.
CFDs also allow you to short sell shares to make profits from the falling price. You could also short sell shares by borrowing them from your stockbroker, selling them, then buying them back when the price falls and returning to your broker.
Whether you chose to short sell via CFDs, or by outright borrowing doesn’t make it any less risky. You risk unlimited losses since the price of the stock can start rising with no ceiling to stop it. You end up recording maximum losses.
Karan from UKs SafeForexBrokers.com warns that new investors must avoid speculation using leverage instruments as there is a high risk of capital loss. CFD brokers in the UK are required to have a warning on their website on the dangers of CFDs and investors should not ignore those warnings. CFDs gamify shorting of stock and expose young investors to losses without borders when prices start rising contrary to their speculation.
As a new investor always take long positions because when you do so the worst that could happen is the share price falling to zero. A nasty experience where you lose huge amounts shorting stock can disenfranchise you and make you lose interest in investing.
First-time stock investors are faced with numerous risks which could constitute an unpleasant experience for them. The capital market is embodied by several risks such as trading complex derivatives, buying penny stocks and low-quality bonds etc.
Nevertheless, with due diligence, adequate research and full adherence to the principles of stock investment, the journey could be fascinating & a great learning experience.