Investing in the share market for yourself can be a daunting prospect as at the top of your mind is the prospect of permanent capital losses.
No one likes losing hard earned savings and it's true that the share market presents risks around capital losses. However, serious retail investors will understand two basic rules to improve their share market returns.
- Not diversifying – This is a basic mistake and greatly increases your risk of permanent capital loss, if you have all of your funds in one or two shares only then it's possible your portfolio could lose 50% or more of its value in a short time. If you spread your risk by holding at least 10 high-quality companies your portfolio is likely to rise over the long term, even if a few shares perform badly.
- Don't speculate on companies with immaterial or no revenue – this is a surprisingly common mistake made by inexperienced share traders. There are perhaps thousands of companies on the local market with little to no revenue (let alone profit) selling stories to attract retail investor capital. Just look at how some of the "pot stocks" like Auscann Group Holdings Ltd (ASX: AC8) have attracted gullible retail investors to their medical cannabis stories only for the share prices to collapse over the past year. If you buy 'story companies' with almost no revenue like ResApp Ltd (ASX: RAP) or Getswift Ltd (ASX: GSW) you're likely to learn the hard way how the share market works in separating fools and their money.
Remember the share market exists for two principal reasons; for investors to be able to trade ownership interests in companies (buy and sell shares) and for companies to raise capital from investors.
It's the second reason that amateur investors are often either ignorant of or forget.
However, if you understand that companies want your capital you'll understand why almost every speculative company on the local share market has a compelling story about how it's likely to strike pay dirt (miners), solve a medical frontier (treat Alzheimer's, HIV, etc), or has a tech platform to spin big profits.
The reality is that almost all of them will fail to produce a return on invested capital for shareholders as they want your capital to swallow in terms of employee wages and other miscellaneous costs.
These kind of pre-revenue stocks are often known as 'penny stocks' as their small nominal values can translate to big percentage swings in shares prices i.e. a stock that moves just 2 cents from 10 cents to 12 cents delivers a 20% gain.
As such they tend to attract day or momentum traders that provide much of the liquidity as any reasonably sophisticated investor would avoid companies with no revenue.
Now I've covered probably the two dumbest investing mistakes made by those starting out in the share market in my next article I'll cover three investing mistakes for more sophisticated investors to avoid that will help improve their returns.
