Large saplingThe second article in this Investing 101 series discussed one of the most important risks we face when we invest: being overcharged, either with ‘loads’ (sales commissions) or with annual fees from investment companies.

This third article in the Investing 101 series discusses a number of other risks with investing, some of which we can control, and some of which we can’t. This article aims to raise awareness of what those risks are, and what (if anything) you can do about them.

The Risk of Paying Too Much

Besides charges from your broker or investment company, there is the very real danger of paying more for stocks or mutual funds than they are worth. The old adage is “Buy low, sell high” but how do we know when an asset is priced low or high? Unless you are a skilled professional investor, the truth is: we don’t. (Even a lot of the professionals regularly mess up.)

If you are really interested, there are numerous methods to discover when a stock, industry or sector is supposedly worth more than its price: value stock picking; growth stock picking; “technical” analysis. But I don’t recommend any of these; they are complicated, they require a lot of time to implement, and they are far, far from perfect. If they were easy and worked regularly, everyone would be getting wealthy in the stock market, whereas research shows quite the opposite.

The best way for beginning investors to invest is simply to buy little bits regularly over time. The fancy name for this is dollar cost averaging but it’s really a very simple concept.

Let’s say you are regularly buying shares in an S&P 500 index fund, which I mentioned in the second article in this series. When I first started buying shares in an S&P 500 index fund, the S&P was at around 1300 (Nov, 2000). Over the next several years, it steadily declined, bottoming out at 815 (Sept, 2002). Looking at those numbers, it’s easy to be discouraged or even alarmed: over two years, the index lost nearly 500 points! I was losing my shirt!

But I sat tight. I knew that the S&P index represented nearly the entire U.S. stock market, that it was in a temporary decline, and it would eventually bounce back (even though I had no idea when; no one did, and this is a key point). Since I was buying small amounts every two weeks, as the S&P sank from 1300 to 815 over two years, I was buying shares at cheaper and cheaper prices.

Since that bottom, the S&P has now risen to over 1400. All those shares I bought at cheaper and cheaper prices in 2001 and 2002 are now worth a lot more than I paid for them. However, as the S&P has risen, it is more and more expensive for me to buy shares. If the S&P 500 index again starts sinking, I will have recently bought some shares at “high” prices. But only a few. Buying a few shares every two weeks, I am averaging out the prices I’m paying over many years, greatly minimizing risk of paying too much at any one time.

Sure, if we were omniscient, we would put in tons of money only when the market hit bottom (in this case, 815) and ride it all the way to the top (it hit 1427 on Dec 15, 2006) and then sell everything, nearly doubling our money. But I don’t know anyone omniscient. We never know when the market will rise, and when it will fall. So the safest course is to buy small amounts, over time, knowing that over the long term, the stock market rises. When the market dips, take heart! We are then able to buy shares very cheap.

The Risk of Selling at the Wrong Time

It is a fact that the financial markets are unpredictable. They rise and fall, sometimes for no clear reasons at all. This is certainly not something any of us can control.

What we can control is our own emotional reactions, and our motives. If our motive is to get rich quick, then every move of the market excites or depresses us, and we are constantly tempted to buy and sell. “Day traders” do this for a living. When the market or a particular company tanks, we are desperate to sell”usually for less than we paid”and we lose money, sometimes a lot of money at once.

But there is also a hidden way can we lose money, in little bits at a time. Every time we buy or sell a stock or shares in a mutual fund, this is a transaction. And with rare exceptions, every transaction we make incurs a cost, because we are paying a middle man (a broker or an investment company) to make the transaction for us.

One of the cheapest ways I know to make an individual stock transaction is through Charles Schwab and it still costs $12.95 per transaction. There is also Sharebuilder where it is $14.95 per transaction. If we are only investing in amounts of a few hundred or even a few thousand dollars at a time, these transaction costs are really expensive. Even if we end up making money on the stocks or funds we trade, buying and selling a lot is going to rack up a lot of these transaction fees, taking away much of our gains (or adding to our losses).

Buy and Hold with little to no transaction fees

However, if our motive is to gradually improve our financial situation, and we take a long-term view, we need not be frightened by the short term moves of the stock market. We know that day to day, and year to year, the market will rise and fall, but over the long term it will probably do very well compared to any other investment.

So our strategy becomes “Buy and Hold.” We buy in little bits at a time (which minimizes the risk of paying too much) and we hang on to it (which minimizes the risk of selling at the wrong time).

This “buy and hold” outlook also dramatically custs down on transaction costs. I mentioned that an individual stock transaction at Sharebuilder is $14.95 a pop, but if you invest regularly, through automatic purchases, you can get your individual transaction costs down to $4, $2, even $1 each.

Of course, if you prefer mutual funds over buying individual stocks (as I strongly do) you will find that Vanguard and Fidelity charge no transaction fees at all to buy shares in most of their funds; but they do charge “redemption fees” if you sell quickly (less than 90 days). This is to your benefit, and minimizes the risk you will sell at the wrong time.

The fourth article in this six-part series will discuss how to avoid another major risk: the risk of all your eggs in one basket.