Classic Stock Market Mistakes

The world-famous IPO

The Initial Public Offering (IPO) is the birthday of a publicly traded company. If the underwriters have done their job, a lot of people will want a piece of the newborn. As a result the price per share opens at $15 and heads north, sometimes the migration continues to triple digit land. Sounds great right? Place a market order first thing in the morning and kick back. Be careful. Eventually the baby’s novelty wears off (maybe there is an odor issue) and the price will retract significantly. This can happen in the first day of trading. The price might peak at $50 a share and close around $20 a share. The moral of the story is don’t buy after market IPOs.

Just ask my Mom. She had been investing for years, so when she heard the queen of homemaking, Martha Stewart, was going public, she whipped out the old checkbook. She specified through the family broker the number of shares to be bought (normal market order). Based on her calculations the purchase should have set her back approximately $1,000. The demand for Martha’s stock was significant. The price quickly shot up to $40 per share before the broker could execute the trade. As a result the $1,000 investment just turned into a $5,000 investment. Oops. Mom had to locate $4,000 overnight. Furthermore, this happened more than a year ago and the current price has not revisited the IPO highs where she bought. Fortunately, my mother (the "Martha disciple") is a wise long-term investor which will likely pull her out of this situation.

What is the moral of the story? Buy after market IPOs after they have come down from their initial spike. This may require months or years. The only way you can buy before market IPO shares is through the traditional broker that is underwriting the IPO. The underwriter (Morgan Stanley, Merrill Lynch, and so forth) can sell before market shares to their preferred customers well below the after market IPO predetermined price (~$18). Not a bad deal. Someday, perhaps, we will be able to invest in premarket IPOs via the Internet. Until then, leave IPOs alone.

Deer-in-the-headlights syndrome

For most people, investing in the market is a frightening experience. Fear can paralyze the would-be investor. Frozen is his or her tracks, the would-be investor cannot act. Instead of jumping on the compound train for a ticket of $27.99, the train runs him or her over. This is a sad story. Don’t let the lights of Wall Street overwhelm you. Address your fear with knowledge and experience.

After all, the lights of Las Vegas don’t paralyze people. Instead of being scared of the lights, people are attracted to Vegas like moths to a bug zapper. Why do people buy lotto tickets when they know their chances of winning is almost nonexistent? These same people could retire wealthy if they decided to invest their money instead of buying lotto tickets on a regular basis. Human nature is a weird thing. The same people who are willing to buy a lotto ticket are scared to death to invest in the stock market. There is nothing wrong with gambling—if you realize it is a form of entertainment, a distraction from reality. Investing in the stock market is not a distraction from reality. Don’t let fear keep you out of the market.

Don’t buy stocks as if you were buying socks

We are the kings and queens of consumption. The United States is more or less a free-market, consumer-driven organization. Americans, otherwise known as consumers, are conditioned to spend more money than they make. Why let reality curb your spending? Price drives consumption. The lower the price, the more units sold. This mentality is so pervasive it can spill over to the stock market. Don’t buy stocks as if you were buying a consumer product. Do not apply sales and pricing concepts to the stock market. Future earnings growth is far more important than price per share. Try to view stocks as equally priced vehicles that travel at different speeds (future earnings). Shop for the fastest rig on the lot not the cheapest rig on the lot. Do not roam around Wall Street looking for a blue light special. Buy cheap socks. Invest in fast-growing stocks.

Don’t try to squeak a cash flow out of your portfolio

Many people buy high dividend yielding stocks to avoid risk and ensure some sort of guaranteed return or possibly a check. Remember, if you do not reinvest the dividends, your investment will not grow geometrically. Stocks that issue dividends are usually old creatures that are not expecting much in future earnings growth. There is nothing wrong with a company that is expected to grow more than 20 percent and issues a 3 percent dividend. The only problem is finding such a critter. Growth requires resources, that is, money. How can you fuel growth and give money to the shareholders at the same time? You should consider avoiding companies that issue dividends especially if you are not investing IRA money. Dividends are taxed as ordinary income. If you are trading in a general account, dividends will increase your overall tax burden. The stock market will not produce a consistent cash flow. You can squeeze out a consistent cash flow elsewhere with no risk (CD, money market, savings accounts). The stock market is not geared toward guaranteed returns. It is geared toward long-term appreciation.

Add to your winners and get rid of your losers

Consider adding to your winners if the P/E has not changed significantly from where you bought it. Consider selling your losers, regardless of the P/E. Guess what? Almost everyone does the exact opposite. They see a short-term profit and they find it hard to resist the temptation. “Look at me. I am the best stock picker on the street.” Sure you are. Stock pickers, like nose pickers, are not revered anywhere. If someone you hired is making you rich, do you fire them? Hell no! You slap them on the back and congratulate them. If someone you hired is losing money for you, do you downsize him or her? Hell yes! You are the boss and you have the power to hire and fire whomever you please. Don’t keep the losers and fire the cash cows. Consider doing the opposite. Winners are hard to find, so when you find them do not throw them away.

Pre-tax profit and after tax profit are two different things.

Most people do not consider tax implications before they start investing. They think the pre-tax profit and after-tax profit will be roughly the same independent of investing strategy. Nothing could be further from the truth. Unearned income is not treated equally with respect to taxation. Dividend and interest income are taxed as ordinary income, capital gains are not. Therefore, if you are not investing IRA money you should avoid earning interest and dividends. Of course, if you are investing IRA money you are a pretty savvy investor who does not need a lecture on tax issues. Annual tax trimming of profits in general accounts will kill your chances of retiring financially independent. Open at least one IRA account as soon as possible. The Roth IRA is perfectly suited for investing small amounts of money for the long-term. Think about the tax implication before you start investing.

Novice investors pay attention to the so-called experts

The world is full of lemmings and doomsday predictors. The stock market has god-like figures that greatly influence the market over the short-term. Unfortunately, the stock market gods do not live on Mount Olympus. They normally reside in large brokerage firms that make a living selling and buying stock (wink, wink). If they want you to sell stock, they pan economic minutiae for the slightest sign that the sky is falling. When they declare the sky is falling, the lemmings sell and the gods make a profit. If they want you to buy stock, they declare prosperity and growth for all, and the lemmings buy and the gods make a profit.

The cycle between disaster and fortune might be as little as a month or as long as a year. The lemmings don’t know what to do. To jump or not to jump, that is the question. Over the long run the Wall Street gods add no value and they should be ignored completely. They make fortunes (billion-trillion ballpark) manipulating the lemmings. Do not let the gods manipulate you! Follow your game plan.