Investing is an important part of your financial plan. However, you must be careful not to fall into any pitfalls. Below are some common investing pitfalls that you must look out for.
1. Investing more than what you can afford to lose
Investing is inherently risky. After all, nobody can predict with 100% certainty whether a company will succeed or fail. As such, there’s always a chance that you may end up losing the amount of money that you put into the stock market, cryptocurrency, precious metal, etc.
Therefore, I recommend that you focus on setting up your emergency fund and setting aside any money required for your immediate goals first before investing your money (you may want to use these frugal living tips!). Although you may have some opportunity costs since you are not investing as early as possible, you can sleep at night knowing that your more pressing needs are taken care of.
2. Not understanding your risk tolerance level
The general principle is that the higher the risk, the higher the return. However, when you envy that one person who manages to make a lot of money through investing, you must not forget that there are probably more people out there who are losing through the same thing.
Things are great when markets are going up. However, what would you do when the markets start going down? Will you actually be comfortable seeing your investment portfolio dropping 35% over a short week, or will you be frantically checking your portfolio every waking minute?
Close your eyes and picture these scenarios in your mind. Your true self will tell you how much risk you can tolerate. Do not invest in anything riskier than what you can truly tolerate, even if the expected return is higher.
3. Expecting that your actual return will equal the expected return
Expected return measures the amount of profit or loss an investor can expect to receive on an investment.
For example, if your investment portfolio has 40% chance of receiving an 8% return and a 60% chance of having a 3% return, then your expected return is 40% x 8% + 60% x 3% = 5%.
However, just because you expect to receive a 5% return does not mean that you will actually receive 5%. There are a lot of factors at play, including your time horizon, unexpected events (I mean, look at COVID!), risk level measured by standard deviation, when you enter the market, the likelihood of the positive return happening (e.g., think about 0.0001% of winning $10 million; the expected return is still positive), etc. Therefore, making investment decisions purely based on expected return calculations can be quite dangerous.
Of course, the expected return is an important measure to look at when you are evaluating an investment decision, but it shouldn’t be the only thing you look at. You should always review the risk characteristics of the opportunity to see if it aligns with your risk tolerance level.
4. Blindly following the advice of unqualified individuals
Just because someone else makes (or claims to make) a lot of money from a certain investment opportunity doesn’t mean that you will also profit from the same thing. He/she could have just gotten really lucky, whereas you may just be entering the market at the peak!
Whenever you hear about an opportunity to invest, do your own research! Understand why a certain company is doing well, why an opportunity may be suitable for you, and even simply whether the opportunity is legit or not.
5. Mixing emotions with investing
Investing can be truly emotional. It is exhilarating to see the stock market go up, but it also hurts to see the share price of a company that you dearly love loses half of its value within a few weeks.
Sometimes, you just have to admit to yourself that the boat has sunk, and it is time to say goodbye. Knowing when to cut ties with a losing position can save you a heartbreak – it still hurts, but if you continue, you may hurt more.
Impatience goes hand in hand with “mixing emotions with investing”. It may prompt you to trade more frequently than necessary and thereby incurring more transaction fees, or it may cause you to exit or enter the market when it isn’t the best time.
Patience and discipline are key to a successful investing strategy. Market cycles are inevitable and you will see ups and downs, so you should be prepared for them well before they arrive. Plan ahead of time how you will react to significant market changes, and stick to your plan when they happen.
7. Buying back stocks too quickly after selling
When you buy back a property (can be stocks, cryptocurrency, etc) almost immediately (usually defined as within 30 days) after selling it at a loss, you will trigger something called “superficial loss”. A superficial loss is denied and added to the cost base of the property.
Here is an example of a superficial loss:
- Dec 1, 2019: you purchased 100 ABC shares at $5 per share
- Dec 18, 2020: you sold 100 ABC shares at $4 per share, incurring a brokerage fee of $20
- Jan 2, 2021: you purchased 100 ABC shares at $4.50 per share
This means that for your 2020 tax return, you cannot claim a capital loss of (4×100-20) – 100 x 5 = $120, because this is a superficial loss. However, you can add the $120 to the cost base of your ABC share. As a result, on Jan 2, 2021, your cost base for ABC share is 100 x 4.50 + 120 = $570.
8. Not understanding the tax consequences of transactions
At the end of the day, what we care the most about is maximizing our after-tax money. Not knowing what tax consequence you will face when you buy/sell an investment product could lead to wrong investing decisions.
Here are a few basic concepts/items that you should understand:
- Capital gain/capital loss rules (including inclusion rates, carry-forward periods, etc)
- Rules related to dividends (eligible vs. non-eligible dividends, dividend gross-up, etc)
- Possible vehicles to shelter or defer your tax payable (e.g., TFSA, RRSP, Roth IRA, 401(k), etc)
I have written a separate post that goes into details about the various tax rules. You may want to check it out here.
There you have it, the 8 most common investment pitfalls that you must avoid. If you keep them in mind, you will have a much better chance of becoming a successful investor.