4 mistakes young investors make

By Larissa Fernand |  04-08-20 | 
 

Recently, a fair number of young investors have reached out to us expressing their desire to dabble in stocks. On the one hand, we appreciate young people showing a keen sense of saving and investing. But what comes to mind, is this:

Individual stocks are TERRIBLE investments for people just starting out.

Christine Benz (CB), Morningstar’s director of personal finance, recently tweeted that and, going by the feedback, it clearly touched a raw nerve. Even though she emphasized that it was only for investors who are just starting out.

John Rekenthaler (JR), Morningstar’s vice president of research, despite being very amused with the word “terrible” in caps, reiterated her views.

They both shared their individual perspective which was so very informative. I have collated the pertinent points here.

Disclaimer: If you are an experienced investor with a well-thought-out portfolio that's large enough to be diversified, it's a good idea to buy individual stocks. But if you are a 22-year-old with a few thousand rupees, you are much better off putting it into a fund. Read a few investing books to develop a basic appreciation for investment fundamentals, valuation, and diversification, before proceeding.

Mistake 1: You think you are on to something.

CB: On Internet forums and social media, fractional shares have been touted as a way to obtain exposure to "all of the FAANG stocks"--as if holding Facebook, Apple, Amazon, Netflix, and Alphabet (Google) makes for a well-diversified portfolio.

More recently, penny stocks have been having a moment: Investors crowded into dirt-cheap Hertz shares after the firm announced its bankruptcy; the stock price lifted, only to fall again a week later. Data on what Robinhood's investors are buying and selling, shows that the free trading site's investors have been investing in an odd mix of FAANG stocks and beleaguered travel-related names, such as American Airlines and Carnival Cruise Lines.

I know, each market is different. But some of this mania, particularly for the FAANGs, does recall the late 1990s, when investors crowded into "can't-miss" tech names like Cisco and Microsoft in the late stages of their long-running ascent. Microsoft has soared after stumbling badly in the "tech wreck" that ensued; Cisco has underperformed the market. Many other names that soared during that period have been relegated to the dustbin of history. (Remember JDS Uniphase? I didn't, either, until someone referenced it recently.)

I can't help but wonder whether the newbie investor enthusiasm is just the latest in one of many speculative waves we've tended to see toward the end of various market cycles, such as the late-1990s dot-com mania and residential real estate earlier this century.

Mistake 2: You believe that you can’t go wrong with cheap stocks.

JR: Few weeks ago, stocks trading under $1 per share suddenly surged. Some of that performance was rational, as signs of economic recovery boosted the corporate weaklings that often (although not always) have low prices. Much, however, was based on nothing more than numerology, with investors believing that $1 can more easily become $2 than $100 can become $200.

The most-cited low-priced example was Hertz Global Holdings, which jumped from $0.83 (June 3) to $6.25 five days later--a 553% gain, which if sustained for a full year would permit the fortunate investor to own an island. The stock has since receded to $1.40, which is roughly $1.40 more than most experts think that Hertz is worth, since it currently is engaged in bankruptcy proceedings.

Buying penny stocks solely because they are cheap is speculation. So too is the strategy of purchasing stocks because they have already risen, known as trend-chasing. Both approaches can masquerade as insightful if the investment environment is friendly. However, profiting from emotion is unsustainable. Eventually, as with the collapse of the new era technology stocks, those who invest on instinct are punished.

Mistake 3: You are under the impression that you will learn the ropes of investing if you start investing in stocks directly at a young age.

A counterargument is that making mistakes is part of the process.

CB: Investors I respect, note that making their own mistakes with individual stocks had been part of their own investing education, helping them build an appreciation for diversification and maintaining a long-term orientation. They argue that investing in actual companies, in contrast with a broadly diversified equity fund, made them aware that they were buying small pieces of actual businesses, something that might be lost on buyers of a fund.

Others noted that making mistakes when you're investing with small shares of money and you're young enough to recover from them might be part of the process.

Those are all good points, but even small sums, invested well, can add up to serious money over a young investor's time horizon; wasting even a few of those early years with misguided experimentation can have a decent-sized opportunity cost. And while doing something is indeed often the best way to learn about it, we're not consistently hands-on in other parts of our lives.

If my car started having problems, no one (and I mean it, no one) would suggest that I go out to the garage and try to fix it myself to help cement the value of getting a professional to do it in the first place. Why would we suggest that investors not start with a professional solution first, too?

JR: The defense to the counterargument that losing money teaches novice investors a valuable lesson, is questionable. Surely there are better ways to learn that fires burn than to put one's hand into a flame.

Besides opportunity cost, the young investor who starts with stocks courts the danger of performing so badly as to become disillusioned, thereby abandoning equities. As Mark Twain said, a cat that jumps on a hot stove will never make that mistake again--but neither will it jump on a cold one.

Mistake 4: You are positive you will beat “the market”.

CB: It's wise to recognize that you're playing against professional investors, people who are paid handsomely to beat the market or at least other funds that invest like they do. If the public track records of those professionals don't make a resounding case for active management what makes you believe you'll be able to do so?

JR: The math is unfavourable for the direct-equity investor. The stock market indexes are propelled by a relatively small number of huge winners, which drag the silent majority along with them. Over history, the median lifetime return for a publicly traded U.S. stock has been worse than mediocre; it has been negative. Investors who buy individual stocks therefore post skewed results. The happy few perform very well, while the unhappy many lag the indexes--and the index funds.

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