Investing in shares – common mistakes to avoid

It feels a bit precarious for share investors these days. Stock markets are going through a turbulent time, and it can be difficult to make investment decisions.

When the market falls, seemingly high dividend yields and low valuations can make shares appear appealing, even against a background of economic uncertainty. But this can be misleading and actually increase investment risk. It always feels easier telling people what they can do to improve their chances of investment success, rather than criticising what they do already.

Over the long term, investing in a broad basket of shares has generated better investment returns than lots of other asset classes. But as ever, remember all share prices can go down as well as up.

With hindsight, we can always look back and say what we could’ve done better, but there are some common mistakes made by even the most experienced equity investors. Here’s how to avoid these.

Investing in individual companies isn't right for everyone. That's because it's higher risk, your investment depends on the fate of that company. If that company fails, you risk losing your whole investment. If you cannot afford to lose your investment, investing in a single company might not be right for you. You should make sure you understand the companies you're investing in and their specific risks. You should also make sure any shares you own are part of a diversified portfolio.

This article isn’t personal advice, if you’re not sure if an investment’s right for you, seek advice. All investments and any income they produce fall as well as rise in value, so you could get back less than you invest.

It’s not all about the share price

Investing in shares can conjure up images of high-octane screen-filled rooms in Wall Street. But we warn against short-term trading, and just focusing on movements in the share price.

Dividends are a key element of the total return you can earn on your investment. Not all companies pay one, but since 1945 dividends have contributed about 33% of the total return of the S&P 500 (an index which tracks the performance of 500 large companies listed on stock exchanges in the United States). Dividend pay-outs can also offer some offset to swings in the share price. Remember though, no dividend is ever guaranteed.

If the dividend is well covered by cash flows, that can be a good sign that the dividend is sustainable. And the ability to grow the dividend is another factor to consider.

Dividend growth can be a strong driver of a company’s share price. The ‘Dividend Aristocrats’ for example, a group of S&P 500 index members that have paid and raised a dividend for at least 25 consecutive years, have a solid record of outperformance. As ever though, past performance isn’t a guide to the future.

But if it’s too good to be true it probably is – beware the yield trap

We shouldn’t just look at the yield in isolation either. A company’s forward dividend yield is its forecasted dividend per share, expressed as a percentage of the current share price.

Recent market volatility has seen some big swings in share prices of late. Meanwhile market forecasts can be slow to catch up with the reality of difficult economic conditions. This has generated some eye-catching forward dividend yields, with some companies expected to pay out much higher than usual cash returns.

Given the pressure on profits at the moment, these higher yields are more likely to be a function of falling share prices, than increasing cash pay outs in some cases. That could mean the market doesn’t trust the analyst forecasts. And here we have a double risk. Firstly, the actual dividend pay-out is lower. But also, that analysts cut their forecasts, which in turn could drive the share price even lower. A useful reminder that figures shouldn’t be looked at in isolation and why it’s important to consider the bigger picture.

Don’t put all your eggs in one basket

History has proven there’s no such thing as too big to fail, and when it happens it often catches investors by surprise. Some of the highest-profile collapses of recent years include Carillion, Lehman Brothers and Quindell.

When a company enters insolvency, shareholders tend to be at the bottom of the pecking order. There’s often nothing left once all the assets have been liquidated and creditors have taken their piece of the pie. You could stand to lose your entire investment.

These are extreme, and thankfully rare occurrences. But companies can and do struggle, and so do their share prices, for various reasons. Diversification will help manage some of that risk. Diversification holds the clue in the name, it’s about holding a diverse range of assets. That way if one struggles, the others can, in theory, pick up the slack.

There’s no fixed answer as to how many shares to hold. The more stocks you hold, the more the risk is spread. But there comes a point where adding one more share to the basket doesn’t really move the dial. Too many holdings can make it harder to run an investment strategy based on your own convictions and research.

Diversification – it takes more than a handful of stocks

This is something we can help with – our share research team cover 110 stocks. Sign up now and pick the shares you want to hear about.

You can also take diversification a step further by investing in funds or other asset classes like bonds or property. Diversification over sectors and markets can help smooth the bumps in the road.

How to build a portfolio

Don’t chase your losses

Not wanting to sell something for less than you paid for it is natural. But heavy falls need to be examined on a case-by-case basis. Was this triggered by a wider sell off in the stock market? Or has something changed that alters your view on why you first bought it?

These might include a dominant market position and high margins. Or particular growth drivers that can see revenue, and more importantly profits, build faster than the competition.

If these attractions are no longer valid, then holding on to make your money back is a dangerous route to take. Just because a share price has halved, it doesn’t mean it can’t halve again.

The dotcom crash at the turn of the millennium comes to mind. After a stratospheric rise, the NASDAQ composite index tumbled 62% between February 2000 and March 2001. By September 2002, it had collapsed a further 38%.

Some of the survivors have gone on to become incredibly successful. Others were arguably ahead of their time, but didn’t have sustainable business models and are no longer trading These include pet supplies retailer Pets.com, fashion retailer Boo.com, and online grocer Webvan.com.

Deep dive into stock market drops – lessons from history

Don’t just follow the herd

Momentum generates momentum, and sometimes we see shares enjoy market-busting performances with no relation to the company’s financial performance.

A case in point is GameStock, who in January 2021 saw its share price practically double day after day. The shares saw lots of bounces in both directions in the following months. But these swings are impossible to predict and are high risk. Trying to time the market is speculative and doesn’t usually end well.

We prefer to have conviction in quality companies over a longer period. Our approach to research is based on fundamentals. This includes an assessment of the company’s management, products and strategy. And also, metrics like growth, profits, yield and valuation.

Valuation is very different to price. As the famous Buffett saying goes, ‘price is what you pay, value is what you get’. It’s also best to compare valuations and future prospects with similar companies. The average valuation of a mining company will be very different to that of a technology giant. The most relevant measure of valuation, be it asset or profit based, depends on the company’s industry and its stage of development.

If the profit or valuation looks too good to be true, there might well be a good reason. Don’t be afraid to dig deeper.

Different types of profit – an investor's guide

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