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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.
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.
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.
