4 Risks of Investing Before Understanding the Fundamentals
With financial markets in turmoil, now could be the perfect time for new investors to enter the market. Just this year alone, the S&P 500 has fallen over 20% creating opportunities to purchase stocks at significantly lower prices. It’s critical for new and inexperienced investors to understand the importance of educating themselves on the fundamentals of analyzing potential investments.
Unfortunately, the market is full of misleading and confusing information. Investors that are influenced by this information can experience heavy losses without a way to validate that they are making the right decisions. Here are four of the most common mistakes that inexperienced investors make and how to minimize your risk through proper fundamental analysis.
1. Chasing Past Returns
It’s impossible to predict the future, especially when investing in the stock market. While past performance can provide valuable information, inexperienced investors may rely on these details too much when selecting investments. Unfortunately, the past performance of a stock is no guarantee of future success. For example, Lehman Brothers' stock price leading up to the company’s collapse in 2008 was trending upward. Between 1995 and 2006, Lehman Brothers’ stock price increased over tenfold.
Investors may become tempted to chase companies that have strong historical performance and higher returns. Fortunately, some key data points can help identify stocks that have a high potential for future growth. One of the most popular is the price-to-earnings ratio (P/E ratio).
2. Buying Based on Superficial Growth
Some companies may appear strong on the surface. The outsider looking in may see growth based on their profitability or expansion, such as opening new stores or factories. It’s important to understand that some companies take on massive amounts of debt which can create superficial growth. For example, Hostess Brands is valued at $3 billion but carries over $1 billion in corporate debt. Leveraging the debt-to-equity ratio (D/E ratio) can help investors identify companies that could be artificially supported by debt.
3. Listening to Financial News and Social Media Hype
Humans are naturally driven by feelings such as fear and greed. Investing can be a highly emotional activity. Major market downturns can be especially excruciating as investors watch the value of their portfolios plummet. Unfortunately, this can lead investors to make irrational decisions such as liquidating their investments at significant losses.
The financial news and social media leverage these human emotions to attract viewers and generate revenue. Oftentimes, controversial investing advice is prioritized despite not being supported by solid fundamentals.
Hype in the media has led many investors to make poor decisions. In the late-90s, technology stocks were considered a surefire way to make a lot of money. This all came to a halt when the Dot-Com Bubble burst leading to investors losing trillions of dollars. To avoid situations like this, investors should be wary of what they hear in the news and validate what they are hearing through careful fundamental analysis.
4. Attempting to Time the Market
It’s common knowledge that most markets are cyclical and go up and down. The best way to make money is to buy low and sell high. This is much easier said than done. Inexperienced investors may attempt to time the market in order to increase their earning potential. The challenge is that predicting the market’s low and high points is difficult to accomplish, even for experienced investors. One study by Bank of America found that investing consistently over time can produce significantly higher returns than trying to time the market perfectly.
Understanding market fundamentals or leveraging powerful tools like an AI-based research platform can improve your ability to identify critical moments to increase your investment amounts.
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