New Investors: It’s Dangerous to Invest Like This

My friend Ann wanted to invest in the stock market for quick gains, so she can use it for a vacation, but she had no strategy and no idea what to invest in. I believe she’s setting herself up for disaster. In the short term, no one knows which way the price of a stock is going to go.

Two things jump out at me: Ann wants quick gains and she lacks strategy.

Avoid the mindset of taking quick gains

As Benjamin Graham, the father of value investing, stated, “In the short run, the market is a voting machine but in the long run, it is a weighing machine.” Basically, if more people are buying a stock, its share price goes up. And it’ll move with any news related to the company.

However, in the long term, the stock price moves with the company’s fundamentals. If the company continues to be strong and posts higher earnings over time, its stock price will eventually move higher. No investor can determine when that will happen though.

When Ann was looking for quick gains, she hoped to book her profits within the year for her vacation. What if the stocks she invests in doesn’t cooperate in moving higher? Worse yet, what if the whole stock market tanks? Many investors saw their stock portfolio fall 50% in the financial crisis of 2008-2009.

To ensure capital preservation for the year, Ann should put her money in a short-term GIC instead. Yes, interest rates are low, so the money saved may not be enough for her vacation. In this case, she’ll need to raise her savings rate if she wants the vacation badly enough.

Avoid having no strategy

What scares me the most is that Ann has no idea how she was going to earn her capital gains. She’s essentially viewing the stock market as a casino, which is the wrong way to think about it. Behind each stock is a business. If you don’t believe there’s a better future for the business, why would you invest in it?

Conclusion: What should Ann do?

Ann should increase her savings rate to save for her vacation. If she’s still interested in stock investing, she should view it as a part of her retirement fund. If she wants to be passive, she can dollar-cost average into ETFs, such as SPDR S&P 500 ETF Trust (NYSEARCA:SPY) over time. It’s diversified across 500 companies and sufficiently represents the market, which makes it an ideal first investment for someone who doesn’t want to actively manage their portfolio.

If Ann’s interested in investing in individual stocks, she should read about value investing, which is one of the safest ways to invest for the long term. After she’s comfortable, she can dip her toes in investing in value stocks such as Manulife Financial Corp. (TSX:MFC)(NYSE:MFC), which is selling at a discount to its intrinsic value right now. New investors just have to buy it, collect its dividends, and wait for its share price to go up over time.

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Fool contributor Kay Ng has no position in any stocks mentioned.

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