Don’t Make These Stock Market Mistakes

With so many individuals taking their first crack at the stock market, I figured it would be apropos to write a post highlighting some beginner mistakes I often notice. Don’t worry, we’ve all been there. Hopefully you learn a thing or two and I can help prevent you from making some of these mistakes.

Words of wisdom from Bob Ross

For those who are unfamiliar with dividends, think of them as a “Thank You” payment that you get for holding certain stocks. Whether it be because the company has too much cash (sounds like a problem I’d like to be cursed with), or because they are trying to attract a certain type of investor, dividends are basically a way companies compensate shareholders. Before you get too excited though, keep in mind that dividend yields (percentage of stock price that is paid out every year) are typically only 1–2%. In other words, if you invested $1,000 in a stock with a dividend yield of 1.5%, you’d receive $15 in dividends over the course of the year. That’s not really something to brag about, but it’s better than nothing. Or is it?…

A common misconception is that dividend stocks are better than stocks that don’t pay dividends. While there is some truth to that (as sketchy stocks typically don’t pay dividends), the rule would prevent investors from earning a lot of money in stocks that arguable should not pay dividends. Take Tesla for example, which doesn’t pay a dividend. Let’s say you own one share: would you rather receive a $10 gift from Elon Musk or have him reinvest that $10 back into the business so he can continue to grow Tesla, which in turn would likely increase the stock price by $100 in a year? Obviously, nothing is certain and these numbers are just made up, but you get the idea. Since the company can often earn more than you, why not let them reinvest it for you so the share price goes higher?

On a similar note, I often hear people ask me about stocks that have a dividend yield upwards of 10%. Why bother predicting which stocks will go higher when you can earn a safe 15% every year? Well, you see, therein lies the problem: it’s not as safe as you might think. The first issue is that dividends aren’t mandatory. A company can, for whatever reason, decide to stop paying dividends. When that happens, look out below! Even if they pay out the massive dividends they promised for the entire year, odds are that stock fell by a sizeable amount, often bringing your net position into the red. Believe me, if you see a high yield, it’s usually too good to be true. If it weren’t, everyone would’ve already bought the stock, driving its price higher and reducing the yield back to normal levels (1–5% depending on the industry).

In summary, I like to tell people that dividends are like white dress shirts. They are usually a safe bet, but that doesn’t mean there aren’t coloured dress shirts that look great too. Similarly, just because a dress shirt is white, that doesn’t necessarily mean it’s a good choice.

Now, you might be thinking that those two words basically mean the same thing but let me give a simple example to highlight the difference.

All-you-can-sample chocolate, also known as heaven
All-you-can-sample chocolate, also known as heaven
All-you-can-sample chocolate, also known as heaven

Let’s say you walk into a chocolate store with only a $20 bill. Naturally, you want to maximize the value of your $20 bill, so you start browsing the aisles looking for some goodies until you come across your favourite candy: M&M’s. This store is self-serve, so you are about to scoop hundreds of M&M’s into your bag when you notice the outrageous price of $20 per singular M&M. Obviously, that’s way too expensive, no matter how delicious. But then, you catch a glimpse of a 6-foot, 50-pound Toblerone. You tell yourself that an item of this size must be worth upwards of $300. Curious, you check the price: $50. Wow, what a deal! Too bad you can’t afford it…

Now, rerun the same scenario but with $100. What would you purchase? Unless you hate Toblerone or enjoy overpaying for stuff, you likely bought two Toblerones for $50 each. So why did I use this analogy? Sure, chocolate is “rich”, but there’s more to it than that.

Let’s bring it back to the stock market now, replacing chocolate brands with public companies. Although you could buy five stocks for $20 each, you are still overpaying because the company is worth so little. On the other hand, you could buy two stocks for $50 each, which may seem more expensive, but it’s actually a much better purchase.

When I ask people why they don’t like purchasing stocks with high stock prices, they usually give me one of two reasons:

1. Well, if a $20 stock and a $100 stock both go up by $10, I’d much rather own the $20 stock because that’s a 50% increase as opposed to a 10% increase. The $100 stock would have to go up $50 per share in order to earn the same amount.

2. Well, a $100 stock has a lot more room to fall than a $20 stock.

The first argument is fair, until I mention high-priced stocks move just as much as low-priced stocks. It’s not uncommon for a $4,000 stock to sway $500 in a single session, so the percentage increases are actually extremely comparable. The second argument is also fair… on a dollar basis. On a percentage basis, both stocks can drop by the same amount: 100%.

Never, that’s when. So why is it that investors get all excited when a company announces a stock split? Well, it usually has to do with the previous misconception about expensive versus affordable. While there are people who cannot afford a $4,000 stock until it splits 4-for-1, their contribution to demand is basically immaterial (usually).

Without stock splits, investing would just be for the ultra-wealthy, so I’m thankful for them. That being said, don’t let them fool you. The stock isn’t any cheaper, it’s just more affordable.

Here’s a tip: if someone lets you in on a secret, it’s likely not that much of a secret. If a company develops the cure for cancer and you are the first person to be in on the secret, you could make millions by investing in their stock before everyone else (assuming this is not insider trading). I hate to break it to you, but this virtually never happens, even though investors constantly try to find the next big thing.

While it’s fine to speculate that your stock might be the next Amazon or the next Apple, you have to understand that the probability of this happening is extremely low. Not only that, but if someone tells you they found the next Amazon or the next Apple, chances are everyone else already knows about it too, so you’re already late to the party.

Just to clarify, I want to emphasize that it’s okay to speculate and that there is lots of money to be made using this strategy. What I’m trying to highlight is that the potential upside is usually offset with large risks and high probability of failure. At the end of the day, it all comes down to your personal investment goals and risk tolerance.

If your reason for buying a stock is “Well look at the chart! The stock has been going up for so long, it’s just gotta keep going!”, then I have bad news for you. This is actually one of the ways people lose the most amount of money (just look at stock charts around 2001 and 2007). Although Newton was great in physics, his law of inertia does not extend to the stock market. That is, a stock in upwards motion does not have to stay in an upwards motion.

Don’t let these misconceptions scare you away from investing. I’ve made these mistakes before and I’m still here, so don’t worry. My goal is to make sure you are aware of them so you can make more informed decisions. That’s why I started Stocks Club. If you liked this article be sure to follow us on Instagram (@letstockaboutit) or on the web at www.stocksclub.ca for more information.

As always, please share this article with your friends who might find it helpful. Let me know what you think in the comments, and feel free to reach out if you have any questions. Have a good one! :D

Just trying my best to have a positive impact on people's lives