Why stock market is a risky business for novices

Posted on: 15 September 2010 by Clem Chambers

Trading in stocks and shares looks like an easy way to get rich quick. Unfortunately, most novice traders are likely to get poor even faster.

stock marketOn the face of it, trading in stocks and shares is easy money. All you need to do is to sign up to a few training courses and work from home. A beginner is promised that they can soon be making a comfortable living.

If only it was that simple.

Sadly there is no guaranteed “get rich quick” scheme, only a get poor fast opportunity. To make money in the markets takes the rarest of qualities: common sense.

The basic law of investing is that the more risk you take, the more upside potential you have. This is a balancing act. The market will pay you more to take on a risk of failure. The more pay you want, the higher will be the chance of disaster.

Getting rich quick in the stock markets is like a game of Russian Roulette: the potential prize rises with the number of bullets in the chamber of the revolver.

Nobody wants to play that game.

However you can still make money in the markets without taking massive risks to get rich quick. A little bit more risk means a little bit more reward. A little more reward over time adds up to a handsome amount of money.

We all take risks. People seem to equate taking a risk with taking giant gambles rather than boiling a kettle to make a cup of tea. Both are risks, but they are at opposite ends of the scale. To risk pouring boiling water on yourself, as many do on a daily basis, is more than compensated for by the pay-off of a cup of tea. When many people decide to take a risk on stocks, they sign up for the equivalent of bungee jumping out of an aeroplane.

Having decided to invest in shares, one’s common sense must be engaged immediately. Investing is a skill and it must be learnt.

Let’s take examples of two would-be investors: Fred Sensible and Bernie Silly. They both have £20,000 to put into shares. How would they start?

Fred would buy a couple of books about long-term investing, and whilst reading them would open a brokerage account with the lowest possible fees.

Bernie Silly would buy Trading Your Way To Your First Million. He would open a spread-betting account or sign-up for a Contract For Difference (CFD) broker offering derivatives with exciting leverage.

Fred will trawl the internet signing up to various free sites. He will look at them all with a fair amount of scepticism. With a few pointers from the books he has read, he will draw up a list of 10 stocks and rate them against the criteria he thinks make a share a good buy. He’ll then buy £1000 worth of the best one. That will be his single share buy that week.

Bernie will have opened his trading account and be reading about interpreting charts and how when one line crosses another and some number is more than it was a year ago, he should buy. He is about to buy some shares that meet the criteria in the book when his cousin tells him that a mine in the Congo has discovered the biggest deposit of bat droppings this century. Apparently the Chinese need bat droppings by the shipload. The cousin reckons the share price will double in a few weeks.  

As Bernie now has 10 times leverage, he can actually buy £200,000 worth of shares in this mine. He hesitates a little and buys £50,000 worth. He wants to take it ‘slow.’

Fred’s share falls three per cent, because the market is having one of its falling periods. He’s lost £30 and feels a little annoyed. He is busy picking out his next share. He’s thinking of buying £1000 of a large famous supermarket that will pay him a four per cent dividend. The company seems to be well managed and expanding. It’s top of his list, but he’ll maybe buy in the next day or so when he’s mulled it over a little more.

Bernie Silly’s bat dropping mine has shot up 30 per cent. Apparently there is much more bat poo there than expected. He has made £15,000 in a day. He sells. Wow, he thinks, I’m going to get rich doing this. The company then shoots up another 20 per cent. He curses his luck and he can’t sleep that night thinking about the money he didn’t make. His cousin said the share price would double and because he was such a novice he has missed a quick £10,000. He buys back in another £50,000. The share price falls 10 per cent the next day. His heart is in his mouth when it doesn’t recover. He doesn’t sleep so well wondering how it will open the next day.

Fred has spent £15 in commission meanwhile and Bernie, with his three £50,000 trades, has spent one way or another £1000. Bernie doesn’t mind. He is still ahead £14,000.

Now of course Bernie’s luck doesn’t hold. He goes back to buying shares based on his charts.  He has no opinion or knowledge on the companies he is buying and selling. It is as if he was tossing a coin and calling “heads” or “tails”. The trouble is every time he trades, his costs are eating away at his capital. Like any gambler, sometimes he makes a packet and sometimes he loses a packet. The funny charts he follows sometimes seem to predict the market, but sometimes they don’t. Eventually a bit of bad luck strikes and he’s wiped out.

Meanwhile Fred now has 18 stocks all based on the criteria he likes to follow. These might not be the most sophisticated but he does at least know a bit about the companies he has bought. He has spent about £300 on fees and is well on the way to getting that back in dividends. After a nasty fall in the market, there was a pleasant rise and as he was slowly buying in, he didn’t really notice. However as he is following the shares using a portfolio tool on one of those nice free internet sites like //link www.advfn.com  // ADVFN.com, he can see that he is already making more from the portfolio than the pittance on offer at the bank.

He has changed a few of his criteria for selecting stocks because on reflection they weren’t so smart, but that’s OK. Investing is a learning process. He decides to get the portfolio into an ISA, in 10 years he realises he has a good chance of turning his £20,000 into £50,000.

Clem Chambers is CEO of ADVFN, Europe’s leading financial market website. For free real-time share prices go to: www.advfn.com

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