Buy a stock because it has a good "story."
Buy a stock because of a tip.
Buy a stock right before earnings.
“OCTOBER: THIS IS ONE OF THE PECULIARLY DANGEROUS MONTHS TO SPECULATE IN STOCKS. THE OTHERS ARE JULY, JANUARY, SEPTEMBER, APRIL, NOVEMBER, MAY, MARCH, JUNE, DECEMBER, AUGUST, AND FEBRUARY.”
Much has been written on how to make money in the stock market. Some of it is valuable: "Buy stocks with steadily increasing earnings and dividends." And, some of it is dubious: "Follow my super easy momentum oscillator system and turn $1,000 into $1,000,000!" Yet, equally important and seldom discussed is how to NOT lose money in the market. Indeed, a certain Mr. Warren Buffett's first rule of investing is, "Never lose money."
In this article, I present three ways to lose money fast; the idea, of course, is to avoid these traps and pitfalls, myself included, and earn money on our investments.
Courtesy of: Stockcharts.com
1. Buy a stock because it has a good "story."
Everyday, we are inundated with news stories and promotions that tempt us to buy individual stocks, or focus on particular industries. "EV's are causing a lithium shortage... buy lithium!" "Everything is computerized these days... buy semiconductors!" "Peak oil is almost here... buy oil stocks!" These statements appeal to one of the strongest modes of persuasion, pathos; that is, they appeal to our emotions and invoke in us a sense of panic... something in the nature of, "By Jove, I've got to buy [insert stock symbol of your choice] before it is too late!" We fall under the siren's spell of a "story stock," a stock we buy because "the story" behind it, the rationale, seems like a sure thing. A story stock purchase might go something like this: "XXX is the biggest cobalt mining company in the world, and I just read that the world is running out of cobalt. It is a sure thing, right?" Wrong. Buying stock in a company because of its story without meticulously examining its fundamentals is a sure way to become separating from our money.
Let us examine one naive, relatively clueless young investor, myself, some twenty years ago. Fresh out of college, a new paycheck in my pocket, I was ready to "play the market," or rather, more sensibly, to "invest." I had just heard a rather alarming story--the world's oil fields were drying up. Soon, the only oil to be found would be mixed within the tar sands in the far North. The Yukon. The same Yukon Jack London immortalized in his adventure tales, where men became men or died trying. Riches were soon to be made by these intrepid oil sands exploration companies, but one needed to act fast, before Joe Q. Public caught wind of these money-printing oil sands... What did I do? I bought a bunch of $5 shares in the first such company I could find, Oil Sands Quest. They were way up North in the cold rugged terrain, questing for oil. I liked the sound of that. No, they were not actually selling any oil yet or making any money, and yes, the price chart looked like the plains of Nebraska (in other words, flat), but that was why one need to buy now and beat the rush, before it took off... You know the rest of the story: The shares wallowed in my investment account for years, declining slowly until one day, with no fanfare, trading of the shares halted. The price of my Oil Sands Quest shares had fallen to zero, and they weren't coming back.
Sure, listen to the stories for entertainment, and for stock ideas, but don't act. Instead, research. Explore the company's website. Review company presentations. Read quarterly report transcripts or listen to the calls. Go over the annual report with a microscope. Crunch the numbers and examine exactly what management is saying about the present and future prospects. Then, when you know the "real story," you can make an investment decision.
2. Buy a stock based off of a tip.
Related to buying because of a good story is buying off of a tip. Perhaps it was from an unsolicited glossy pamphlet you received in the mail, touting a "hidden gem" that was destined to be a blockbuster; perhaps it was from your rich Uncle Walt, after a few glasses of wine at a Thanksgiving family get-together; perhaps, less dubiously, it was from a successful investor friend whom you know well and respect; or, perhaps it was from a Seeking Alpha message board. Regardless of the source, buying purely on a tip is a great way to lose money in the market.
Like stories, tips are fine as starting places for research. Throw the symbol on a watch list in the appropriate category (biotech, oil, retail, internet service, etc), and let it simmer as you dive into the fundamentals and examine the technical chart patterns. Then, you can decide on whether to purchase the stock based upon its own merit, not on what your Uncle Walt said. Some of my best stock investments over the years were tickers introduced to me from others, but I have also witnessed countless times a particular stock touted as a rocket ship, only to see said rocket crash and burn or never leave the launch pad. If someone gives you a stock tip, it is often because it has either A) been running up for months and is now dangerously overbought, or is B) highly speculative and has yet to take off but has a promising "story." Either situation is undesirable for the prudent investor.
3. Buy a stock right before earnings.
Here's the situation. You've been watching Acme Widget Company go up for weeks, months, or years, and finally, you now have the money to buy it. Giddy with expectation, you hit the buy button and add 100 shares of AWC to your account. The very next day, to your horror, you discover that it is down 13%. What happened? You forgot to check when the next quarter's earnings were going to be released, and you got burned, bad. Sales were unexpectedly slow at Acme Widget Co., and the stock gapped down; or, Acme posted record earnings, but some of the big share holders decided to sell the news. Either way, your newly minted shares are now sitting in the red zone, and you've got to decide whether to sell now while losses are small or hunker down and hope for a recovery. Not a good choice to make for any investor.
Has this happened to you? I confess, it has happened to me more than once. The final step in your research process is to check the release date for next quarter's earnings. If the release date is within two weeks, wait until earnings are posted and Mr. Market decides how he likes the numbers. Will you miss out on part of a move? Maybe, although stocks tend to slide sideways or correct a bit right before earnings. Will the stock gap up without you on board? Yes, very possibly, but missing out on some quick easy money is far better than suddenly getting hit by the market equivalent of a truck because the stock posted earnings right after you bought it, and its earnings were ill-received.
The other scenario is when you consciously buy right before earnings. Maybe the stock has gapped up the day after earnings for the past three quarters in a row. Maybe you are absolutely convinced the company is going to blow away market expectations. Or, maybe the chart has set up into a perfect symmetrical triangle continuation pattern, volume is drying up, and the stock price is coiling up, ready to explode. Fellow investors, I don't care how great the stock's track record has been over the years; buying right before earnings is not investing, it is gambling. Even with a truly outstanding company, there is always a significant chance that one of these three things will happen when quarterly earnings results are posted: 1. Earnings results did not meet market expectations. 2. Results were good, but the projection for next quarter is disappointing. 3. Results were great, the projection for next quarter's numbers are stellar, but the big shareholders controlling most of the stock price decide to sell the news and bank their profits, and rotate the money to a different stock. Any of these three result in the same thing. You holding the proverbial empty bag. And friends, bagholders are not what we want to be!
I subscribe to a charting service (stockcharts.com) that enables me to annotate the charts, and on every chart I write the earnings release date for next quarter. First I write the estimated release date, and then I replace it with the official date, when it is announced a few weeks before posting time. You can almost always find this information via a quick web search, and you can also look at the date of the prior earnings release. Has it been almost three months since the last earnings were posted? Then an earnings release is nigh. On the other hand, if earnings were revealed just a few weeks earlier, then you are golden. Alternatively, you can go "old school" and print out the charts, draw trendlines or circle cup with handles and what have you, write the earnings release dates on the charts in big red letters, and tape them on the wall. This tangible, old school method is surprisingly satisfying, although your spouse may balk when he or she discovers that you have wallpapered the living room with stock charts!
The trading coaches at MarketSmith recommend selling before an earnings release if you don't have a +10% cushion on your shares. While this kind of concrete rule may be too arbitrary, I agree that if you do not have a substantial profit on the shares going into earnings, then you should think long and hard about holding them. Unless you are absolutely convinced that this stock is a long term winner for months or years to come, regardless of the upcoming earnings report, taking a small loss or banking a small gain prior to earnings is a prudent choice; and yes, you can always swallow your pride and buy those shares back at a slightly higher price, if you sell and then the market reacts favorably to the earnings report.
These are three ways that many of us, myself included, lose money in the stock market. Let us adhere to Warren Buffett's first golden rule of investing, and let us make our stock purchases cautiously. Because, although it is right to jump into a swimming pool with gusto, impressing all onlookers; in the market pool, it is best to ease in slowly and carefully, and to ignore the jeers of fellow investors who have jumped in headlong and are shouting at you to "Come on in... the water is fine."
If you know of other ways to lose money in the market (goodness knows, there are multitudes), I would enjoy reading about them in the comments below, with the hope that your ideas will serve as a warning and help save investors from these pitfalls in the future.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I am not a professional stock analyst or money manager, and the information provided is for educational purposes only; it is not a recommendation to buy or sell a stock. Please do your own research and invest accordingly.