3 stock market pitfalls for beginners to look out for

When investing in the stock market it’s easy to fall foul of these three big mistakes. Our writer considers some examples and how to avoid them.

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The stock market offers a wealth of attractive investment opportunities, from growth and dividend shares to investment funds and ETFs. But it’s easy to get caught out by simple mistakes. A few untimely errors can send an otherwise profitable portfolio spiralling into losses.

Here are three key dangers to avoid.

Trusting past performance

Despite the old adage, there’s in fact no guarantee that history will repeat itself. Many metrics rely on past performance in order to forecast future price action. In certain scenarios, this can be useful — particularly with stocks in cyclical industries.

Should you invest £1,000 in Rolls-Royce right now?

When investing expert Mark Rogers has a stock tip, it can pay to listen. After all, the flagship Motley Fool Share Advisor newsletter he has run for nearly a decade has provided thousands of paying members with top stock recommendations from the UK and US markets. And right now, Mark thinks there are 6 standout stocks that investors should consider buying. Want to see if Rolls-Royce made the list?

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However, there’s a multitude of unpredictable factors at play, including environmental geopolitical events. Not even the most accomplished forecasters can account for everything.

Resorts, cruises and airlines took a battering when Covid hit, despite past performance suggesting years of growth ahead. Major travel group Expedia lost half its value after the pandemic, falling from $17.1bn to $8.1bn.

Defensive stocks like AstraZeneca and Unilever can help shield a portfolio from such events. They typically tend to continue performing well when the wider market dips.

Trying to catch falling knives

There’s a saying in finance: “Never try to catch a falling knife“. In the restaurant industry, its meaning is obvious: you’re going get hurt.

In finance, a falling knife is a stock that’s falling rapidly. Often, such stocks recover just as rapidly, providing a small window of opportunity to grab some cheap shares.

But sometimes, they don’t. If the company’s on the verge of collapse, it’ll just keep falling. Even a short-term recovery (known as a ‘dead cat bounce’) is no guarantee it’ll keep going up. This can happen as a result of other opportunists trying to catch knives but failing to save the stock.

Never buy a stock on a whim. Plenty of research should precede every investment decision. Even if an opportunity’s missed, there will be many others. 

Blinded by dividends

It’s easy to get sucked in by the promise of high dividend returns. Yields can be especially misleading, with some stocks appearing to promise returns of 10% or above. 

It’s important to remember that a yield increases if the share price drops while the dividend remains the same. In other words, a company’s stock could be collapsing, sending its yield soaring. When this happens, the company usually cuts the dividend soon after.

Always assess whether a company has enough free cash flow to cover its dividends. The payout ratio should be below 80%.

A recent example is Vodafone (LSE: VOD). The yield soared to nearly 13% in 2023 all while the share price was plummeting. Then earlier this year, it slashed its dividend in half.

Created with Highcharts 11.4.3Vodafone Group Public PriceZoom1M3M6MYTD1Y5Y10YALLwww.fool.co.uk

Revenue slumped almost 25% in 2023 and earnings per share (EPS) fell to -1p. It now carries a lot of debt, which poses a significant risk.

But things are improving. Following a restructuring plan, a merger with Three was approved on the condition of rolling out 5G across the UK. Moreover, the sale of a stake in Indus Towers has helped cover some debt.

EPS is forecast to reach 8p next year and the average 12-month price target eyes a 27.4% gain. If things continue, it may fully recover. But until then, I don’t plan to buy the shares.

Should you invest £1,000 in Rolls-Royce right now?

When investing expert Mark Rogers has a stock tip, it can pay to listen. After all, the flagship Motley Fool Share Advisor newsletter he has run for nearly a decade has provided thousands of paying members with top stock recommendations from the UK and US markets.

And right now, Mark thinks there are 6 standout stocks that investors should consider buying. Want to see if Rolls-Royce made the list?

See the 6 stocks

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

Mark Hartley has positions in AstraZeneca Plc and Unilever. The Motley Fool UK has recommended AstraZeneca Plc, Unilever, and Vodafone Group Public. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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