Maybe you’d expect from a financial blog tips on how invest your money and become easily rich. But losing money is much easier (at least, for me it is…), so I think it is appropriate to talk about it a little.
In theory, earn money in the stock is quite easy: all you need is to buy shares at minimum price, before value starts to rise, and sell them when price reaches the maximum, before beginning of decline. Easy, isn’t it? But there’s one small problem: no one can foresee the future.
But above all, often come into play some psychological mechanisms: panic and pessimism when prices go down, euphoria and greed when they go up.
How many people would buy something whose value is lowering? How many would be tempted to invest more and more on something which is gaining value? But this means just one thing: people are tempted to buy when prices go up and sell when they go down: but this brings the risk to buy at a maximum price and to sell at the minimum. The exact opposite of what one should do to successfully invest in the stock market. If you are not careful enough, this way you can lose lot of money.
And it’s important to notice that there is no need of large fluctuations in prices. Let’s try to understand with a little example. Suppose we have 100 shares priced 50$ (then 100 x 50 = 5000$). If price rises to 60$, we let ourselves get carried away by enthusiasm and we buy another 100 shares (100 x 60$ = 6000). In total we have now 200 shares, for a value of 11,000$.
At this point, the value drops back to 55$: we fear that the fall will continue, and we sell everything. Selling 200 shares at a 55$ price, we collect 11000$. What we have earned? Nothing, since it is exactly what we had spent to buy the shares. You may think we’ve been lucky, since we didn’t lose anything. But keep an eye on a different scenario: suppose we had not bought the second 100 shares, pressured by greed. If we’d sold the 100 shares when the price reached 55$, we could have earned 500$. If we sold when price was 60$, the earning would have been a good 1000$. Do you still think it was a luck not to lose anything?
I know what you think: this won’t happen to me. But there are a lot of people who in the end throw away money investing on the wave or panic, or greed.
How can we avoid such gross mistakes ? In my opinion, it is important to have a strategy, which should be evaluated as objectively as possible: this means on one hand we need to assess the strategy’s strengths and weakness in relation to your goals, and on the other hand you need to test it. You can do that trying to apply you strategy on past data (but be aware that you can be influenced by knowing what has happened next), or applying it “virtually” (tracking day by day, on real data, what would have happened if you’d followed your strategy). When you decide your strategy works enough for you, you can start investing your money, but remember that you have to follow your strategy, whitout panic or greed, or else you’ll end up losing money.
Another thing you have to keep in mind is that you have to diversify your investments. This on the one hand because statistically diversification reduces risk, but also because this way is easier to think clearly on what is happening: in fact, if the fluctuations involve simultaneously all our money becomes difficult not to get involved by emotional aspects. If we diversify the investment, there will be some divergence of trends (some investment will be in gain much, other less, some maybe will be a loss), that may be very useful to avoid us excesses of enthusiasm or panic.