If done right, investing in the market can build wealth over time. Building a road without preparing the base would be dangerous due to premature wear and tear, potholes, and road erosion. Just as a street with a solid foundation will likely drive more safely and last longer, having a solid base of knowledge before you start DIY investing is key to having a successful outcome.
The gamification of investing through apps such as Robinhood has created a generation of young investors that need to be aware of certain investing concepts that can significantly impact their returns and long term financial security. Before investing, take heed of these five important considerations:
1. Have an investment strategy. Do some homework. Understand what you are investing in and why you’re putting your hard earned money to work in the investments you’ve chosen. Following the herd into "meme stonks" will end badly for the for many "musical chair" investors who are late to the game and can't find a buyer to sell their stonk to when the music stops. Don’t overestimate your ability and don't get emotionally attached to your investments.
2. Get some balance. Diversification means holding some investments that zig when others zag, and some that zag when others zig. Holding all similar-behaving stocks means that everything will move in sync, increasing the potential upside, but more importantly, increasing the scale of potential prospective losses as well. Diversification can be used to potentially reduce volatility, but it does not ensure a profit nor protect against loss.
3. Understand the risk of leverage. Even at the largest investment managers, compliance departments stringently monitor investment advisors who use options strategies and attempt to limit margin loans to reduce the risk that investors take in getting over-leveraged. In the “wild-west” of do-it-yourself investing, many of the trading firms encourage the use of options and margin with minimal approval and next-to-no oversight.
4. No fee doesn't mean "no cost." Platforms like Robinhood get paid by the trade desk for "order flow". The more trades you make the more money they earn. Zero commission investment platforms may increase the likelihood of realizing a loss by taking away your consideration of paying for the transaction. At an open bar at a wedding, a guest may not consider the potential cost of their actions if each subsequent drink is “free”.
5. Uncle Sam will get his cut. The difference between what you paid for an investment and what you sold it for is considered a capital gain or a capital loss. If you held an investment for less than 1 year, the capital gain is considered a short term capital gain and is taxed at your highest marginal tax rate. Held for more than a year, it would be considered a long term capital gain and taxed at a significantly lower rate Remember that these taxes will be due next April 15th.
Billionaire investor, Warren Buffett says “Risk comes from not knowing what you’re doing.” Invest some time in learning about investing before you put yourself at risk of making a big mistake with your money. Try explaining what you're doing to a six year old.
"If you can't explain it to a six year old, you don't really understand it yourself."--Albert Einstein