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3 investing risks you should be wary of

When it comes to investing, many of us are quick to focus on the upside. We all like to think about how we can grow out wealth and build our portfolios up into bigger and bigger amounts. And we certainly can – but unfortunately many investors fail to factor in the risks.

Many of these cautions are well-worn tales, but though they are as old as the hills, they don’t stop green and naive investors making the same mistakes again and again. Here are three investing risks that you should be aware of.

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Never put all your eggs in one basket

This goes against Warren Buffett‘s advice of putting all your eggs in one basket.. and then guarding that basket with your life. But there is one big difference.

Warren Buffett has spent a lifetime investing in companies, reading financial documents, and understanding what drives value. It’s likely that you, on the other hand, have not. I am also in that group, and so Warren Buffett’s advice is not particularly useful to us.

Warren Buffett has earned the right to concentrate his capital. He knows what he’s doing. A new investor who has yet to make all of the novice mistakes and who is not yet battle-hardened should not be placing all of their portfolio into a single stock. 

If it sounds too good to be true… it probably is

It’s easy to be seduced by a blue sky story stock – the sort of stock that nobody really understands, but boy does it sound good! This is the stock that usually sounds great on paper, and is going to change the world. 

And usually, this company is the sort of stock that talks a good talk, but cannot back up the story with sound fundamentals. 

Be careful of stocks that have a good story and a slick-talking sales person fronting it, because very often you’ll be disappointed. 

Never invest in something you don’t understand

Peter Lynch once said that if you can’t draw what a stock does with a crayon, then you shouldn’t be investing in it. In my opinion, he’s absolutely right. If you don’t understand what the business does, then how can you be sure that you are making a great investment?

The truth is you can’t. And if you can’t be sure you’re making a great investment, then you shouldn’t be investing. Most investors will have a certain field of interest that they are well-versed in and more knowledgeable about than the average person. This is where their edge is. Someone who has worked in the plastics industry for 20 years is going to have a much better idea of investing in plastics companies than someone who has never worked in the plastics industry for a day in their lives.

I’m not saying that someone who works in the plastics industry should only invest in the plastics industry (that would be putting all of one’s eggs into one basket), it does make sense to invest in industries that you understand and where you have an edge.

Investing can be difficult, but it will be a lot easier if you avoid making these three mistakes.

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Views expressed 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.