Investing

How to avoid a common mistake that costs investors money

Johannes Eisele | AFP | Getty Images

Recently, oil prices hit the floor and even briefly drilled into negative territory. This led many people to think that it would be a good time to invest in oil: If they bought low now, later they could sell high, after oil prices recovered. So they piled into oil-related investments. Month-over-month ownership of one exchange-traded fund (ETF) jumped 300%.

The rush into oil illustrates a common investment mistake: When people invest in something they don't understand, they often make mistakes that cost them money.

In this case, one of the vehicles many investors used to try and take advantage of the situation is an ETF called USO, which stands for United States Oil Fund. Many people thought that investing in USO meant they were buying barrels of oil that were sitting in storage somewhere which effectively would let an investor "bet" on the price of oil. The problem, though, is that USO tracks oil futures contracts, a much more complicated investment. 

"Oil has like 20 layers of pricing, so unless somebody understands those layers, you're not doing yourself any favors" by investing in the commodity, says Katie Brewer, a Dallas-based certified financial planner who runs the financial firm Your Richest Life.

In fact, the type of ETF or stock that many of these investors were looking for doesn't actually exist. 

That fundamental misunderstanding cost many investors: So far this year, USO's share price is down more than 80%, and down more than 75% since the end of February.

Here's how to avoid making a similar misstep with the next "hot stock tip" or market opportunity that comes your way.

What causes investing FOMO

Fear of missing out, or "FOMO," is a phenomenon that's not unusual among investors who don't want to miss out on a good investment.

FOMO is also something that tends to happen around IPOs, or initial public offerings. When Beyond Meat went public last year, for example, investors snatched up shares and caused the company's stock price to skyrocket. After debuting at $25 per share, Beyond Meat's stock peaked at more than $230 per share before coming back down.

Now, a year after the company went public, it trades for around $90 per share.

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That's actually quite common for IPOs and it's what makes investing in newly public companies so risky.

A recent UBS analysis based on data from a University of Florida professor found that most investments in newly public companies lose investors' money. From that analysis, over 60% of more than 7,000 IPOs from 1975 to 2011 had negative absolute returns after five years.

Oil has like 20 layers of pricing, so unless somebody understands those layers, you're not doing yourself any favors.
Katie Brewer
Certified financial planner, Your Richest Life

Many early investors jumping onto the IPO opportunity didn't understand Beyond's products, its business model, or how it planned to keep growing: They just knew that it was a hot stock that was quickly gaining value. Because they didn't do their due diligence, investors who were caught up in the hype and bought near the peak may never regain the ground they lost.

A lot of FOMO-based investing "seems to be peer-based," says Brewer. A friend or family may tell us about a "hot tip," for example. But blindly following such advice can be a terrible idea, she says: "As a general rule of thumb: If your Uncle Joe told you about an investing idea, you need to do some more research."

How to investigate investment opportunities

Before you invest, take these three steps to make sure you understand the investment and ensure it's a good fit for your portfolio:

Do the research. You should be able to answer some basic questions about the fund, company, commodity, or other asset you want to invest in. "What is the stock trading at? What do the analysts say? Ask yourself questions like these," says Brewer.

Public companies file quarterly and annual reports, which include important data points like earnings that can help guide your decision making. If you don't want to get too far into the weeds, start by simply reading a fund's prospectus or a company's 10-K. That should give you some basic knowledge about what you're investing in.

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Talk to a professional. If you're excited about jumping in on the next big IPO or trying to take advantage of some other market quirk, it's smart to reach out and discuss the idea with a financial advisor or other investment professional. They can help you understand the risks and whether that kind of investment is a good fit for you, given your goals and financial situation.

Kathy Carey, director of research for Baird's Private Wealth Management group, says that some of her firm's clients were calling asking about how to invest in oil, and in USO specifically, over the past couple of weeks. "People were asking," she says. "Luckily, we had an understanding of what those ETFs looked like and could explain what the risk was."

As a result, she says, many of those clients backed off and saved their money.

Focus on core investments. Almost every financial professional will tell you that the best investment strategy is to invest in broad-based index funds or ETFs, and do so for the long-term, a strategy championed by famous investors like Warren Buffett. That means effectively ignoring the day-to-day fluctuations of the market, and investing small amounts regularly in a diversified portfolio in order to reduce overall risk and to take advantage of dollar-cost averaging.

If you've done all that, and have a little bit of money that you want to "play" with in the markets, go ahead, says Brewer. But always be cautious, and make sure you're doing your homework. No investment is a sure winner.

"Make sure you have all other bases covered" first, says Brewer, including having an "emergency savings fund, a fully funded 401(k), and college savings" squared away.

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