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The pandemic, recession and stock market rollercoaster didn’t scare away newbie investors.
A recent Charles Schwab study of nearly 500 investors found that 15% of all current U.S. stock market investors got their start in 2020. The momentum hasn’t slowed: the financial firm says it opened 3.2 million new brokerage accounts in the first quarter of 2021, more than it saw for all of 2020.
There is a lot of market action for new investors to jump into. The S&P 500 and Dow continue to hit record highs, Bitcoin is soaring and a non-fungible tokens craze has people paying thousands of dollars for digital art. Earlier this year an army of traders on Reddit waged a war on Wall Street by sending GameStop’s stock surging, and the meme-turned-cryptocurrency Dogecoin surged more than 8,000% in the first few months of 2021.
But just because there are new trends on Wall Street (and all over the internet), doesn’t mean the rules of smart investing have changed.
“This is not a new era or different than anything that has occurred in the past,” says Christopher Lyman, a financial advisor at Allied Financial Advisors LLC based in Newton, Pennsylvania. “It may look different but it’s the same story that has been told countless times.”
History has shown us that most times investors try to make money quickly, they get burned. But instead of repeating their mistakes, we can learn from them.
So we asked financial advisors: what are the biggest mistakes new investors make?
1. Investing before you’re ready
If you don’t have a solid financial foundation that will help you weather any unexpected storms, like a job loss, don’t make the mistake of investing too early.
That foundation includes creating a budget, paying off any high-interest debt like credit cards and building an emergency fund, says Haley Tolitsky, a financial planner with wealth management firm Cooke Capital based in Wilmington, North Carolina. Experts say an emergency fund should cover three to six months of your living expenses, like rent and utilities.
You also want to take advantage of your employer’s 401(k) match, if you’re offered one, before you start investing elsewhere, Tolitsky says. That’s basically free money sitting on the table, so make sure you’re contributing at least the maximum your employer will match before investing in a taxable brokerage account.
2. Making short-term trades
Day trading — buying and selling with a short time horizon like days, weeks or even a few months — can be tempting. But if you do it with a significant chunk of your portfolio, it can also be really dangerous.
“Trying to time the market is the biggest mistake new investors make,” says Sallie Mullins Thompson, principal at the financial services firm in her name in New York City.
Given that it's not possible to consistently do that, the wiser plan is to develop an investment plan based on goals, time horizon and risk tolerance, she adds. Then, stay the course and stick to the plan, unless your goals or life situations change.
What is the right investing time horizon? Academic research has shown that day-to-day fluctuations in the stock market are all-but random. If you wait for at least one year, you have a two-in three chance of making money. After ten, it's about 19 in 20.
3. Confusing luck and skill
Just because you make money on an investment, doesn’t mean it was a good investment, says Jeremy Finger, founder of Riverbend Wealth Management in Myrtle Beach, South Carolina
Earlier this year, retail investors conjugating on Reddit hiked up the price of GameStop so high they sunk hedge funds that were short-selling the video game retailer’s stock. But when the share price eventually fell, some investors suffered big losses. Another attraction for investors — cryptocurrency — has also proven to be volatile. If you make money on one risky investment, don’t throw your investing know-how out the window.
Diversify your investments and invest for the long term, Finger says.
“The boring stuff works.”
4. Ignoring diversification
Don’t forgo diversification. A well-diversified portfolio that includes assets other than stocks will ensure when part of your portfolio takes a hit, part will remain stable. For example, when stocks plummeted in March of 2020, Treasury bonds held their ground, and investors who held both were probably less anxious when checking their portfolio.
“It’s so easy to get caught up in the excitement of the next big thing and forget about the actual risks involved,” says Matt Stephens financial planner at AdvicePoint in Wilmington, NC. “Having a diversified portfolio is boring by comparison, but can protect you better when things turn the other way.”
Diversify within each asset class as well; your equity investments shouldn’t just be those in the S&P 500, but small and international companies as well.
Diversification will look different for every person, depending on their financial situation, goals and proximity to retirement. For example, someone with more than 10 years until retirement may only have 10% to 15% in bonds and 85% to 95% in stocks, while someone within five years of retirement may have 40% in bonds and 60% in stocks, Money has previously reported.
5. Forgetting about taxes
Investing for the first time can be fun and exciting — until you get the tax bomb.
“While it's great that investing has become more accessible to more people, many first-time investors are not aware of the tax consequences of trading,” says Tricia Rosen, principal of Access Financial Planning, an independent fee-only financial planning firm based in Andover, Massachusetts.
Educating yourself on what you’ll owe in taxes on can help avoid a huge surprise bill when you file. If you sell a security (like a stock, bond or most mutual funds) after holding it for less than a year, any money you make off the investment is taxed like income. But if you hold a security for more than a year, it's subject to capital gains taxes and will be taxed at 0%, 15% or 20%, depending on your income. There are some exceptions, like gold, which are considered "collectibles" and taxed at 28%, even if you hold them in an ETF.
If you get a significant capital gain when selling a security, you may also need to make quarterly estimated payments. The IRS says that generally you should make the payments if you expect to owe at least $1,000 in tax after subtracting your withholding and refundable credits, and if the withholding and refundable credits will be less than 90% of your tax liability for this year and 100% of your tax liability for last year (whichever is smaller).