How to Lose Money In The Stock Market
Alright, there are almost limitless ways to be dumb with your money. This article isn't about making stupid errors with your cash. It's about the real and tangible ways that money can be lost in your investments.
We always hear, "He lost a ton of money in the stock market", but that does that mean? How do people really lose money in the stock market?
Is it possible to invest in a way that makes it hard or nearly impossible to lose money? That's what we're about to find out here!
Realized VS Unrealized Losses
If you haven't already learned about these cool vocabulary words, let me enlighten you.
Unrealized losses occur when your investment declines in value but you haven't cashed out yet. For instance, you buy a share of Coka Cola at $100 and it declines to $90 but you don't sell it. You have experienced an unrealized loss
Realized losses, as you might expect, occur when your investment declines in value and you sell it at that lower value. You have then realized the loss. If you never sell it, technically it's unrealized.
Using Unrealized Losses To Your Advantage
Okay, so who cares, right? The value of your investment went down, what does it matter whether or not it's realized?
Ah! But here's thing! If you hold on to your investment until it goes back up in value above the original purchase price, it becomes an unrealized gain! At this point, you could choose to sell it for a realized gain! Ta-dah!
In reality, it's not quite that simple. The takeaway is this - if your investment declines in value you don't have to sell it. It's an unrealized loss, it's only a loss on paper. Once you sell it you lock in the loss. If you have the stones to wait out the dip in price, it may very well become a gain for you.
Unrealized Losses & Gains
Remember that the value of your investment is not guaranteed to go back up. This means that sometimes you have to know when to fold 'em. Cut your losses and get out!
If you're investing in a total stock market index fund and it dips 20% in the next market correction, just hold on to it. It will come back up and make money for you in the long run. Don't sell out of something like that once it falls because then you have a realized loss.
Holding on to a stock like Enron when it went through the whole scandal and fraud would not have done you any good. You would have lost all your money. That's why you need to understand the nature of each investment you make and choose when it makes more sense to cut your losses and run!
#1 way to lose money in the stock market? Sell on a dip. Lock in that realized loss. Bummer. It could've gone back up!
Want to lose more money than you have invested? Is that even possible? Yep. It's called leverage.
Leverage is just a word for using borrowed money to increase the effects of your investing. We do it with houses all the time. We leverage debt from the bank (mortgage) in order to get something bigger than we can afford (10-bedroom lakehouse).
There is more than one way to leverage your investments in the stock market. Margin trading accounts are the most common! A margin account is an investment account which has been cleared by its broker to borrow money from the broker firm for investments.
It often doesn't take much to get clearance from your brokerage to invest on "margin" or with leverage.
Leverage looks something like this: For every one dollar you invest, you borrow x dollars from your broker to invest.
Using Leverage and Margin Accounts
Of course, you owe them the money back but if your trade goes well you can pay back the broker and keep the gains from their money!
Oh, by the way, it's not a free lunch. They'll charge you for the service.
How Can Leverage Burn You?
Remember when I said that you have to pay your broker back? Well... let's think about this for a second. If you want to buy AAPL stock at $100 per share on 15:1 leverage, you put in $100 and your broker ponies up $1,500.
You've actually spent $100 of your own money to buy $1,600 worth of stock. Like a down payment on a house.
Buckle your seatbelt because these numbers might scare you.
If APPL rises 20% to $120 then you can sell your shares, make $20 on each of the 16 shares, and pay your broker back. You'll pocket $320 in profit from your $100 investment! That's a 320% return on investment!!!
If AAPL falls 15% you lose $15 on your original investment of your own money. As if that weren't bad enough, you also lose $15 * 16 shares borrowed. You owe your broker $240 for a total loss of $255 on a $100 investment.
You ended up losing $155 more than you had originally invested!
Effects of 15:1 Leverage on a $100 Investment
It's worth noting that if a leveraged trade moves against you too far, your broker may issue a margin call. When your broker issues a margin call you'll be forced to pay them for parts of your losses. If you don't pay they can legally sell shares of your investment to make their money back.
That's why it's not always possible to hold on to a trade and ride out the dip with a leveraged trade.
#2 way to lose money in the stock market? Trade on margin and have a trade move against you.
Over-Concentration and Hidden Correlation
How Can Concentration Lose You Money?
Imagine this: You just bought three different Mutual Funds, each with 100 stocks inside. Owning 300 stocks is surely enough diversification to keep you "safe" in the stock market, right?
Turns out that your total stock market fund owns shares of Microsoft. As does the tech fund that you bought. And the large cap fund? Yeah, it also owns shares of Microsoft.
Concentration is when you have a portfolio with a large portion of investments in a single company, sector, or industry.
Concentration can be a good thing. If one industry does particularly well and you're concentrated there on purpose, it will do wonders for your returns!
Concentration can also kill you if it's accidental! If you thought you were diversified equally across the whole market and instead find out that you were accidentally concentrated in Tech... well you could have a nasty surprise if that industry falters.
How Can Correlation Lose You Money?
Correlation is the tendency for to investments to move together. If two things are directly correlated, they move exactly the same. If they're loosely correlated they roughly move up together but often in different amounts.
Investments that seem completely different can often be correlated beneath the surface. In fact, nearly every investment shares some level of correlation.
If you want to learn more, you can read my in-depth article about managing correlation in investing.
If you invest in several different things, assuming that one may go up while the other goes down, you may be fooled. Have you thoroughly checked the correlation of the two investments you've made? No? Not to worry.
There are several ways to check the correlation of two investments, but Portfolio Visualizer is probably the easiest.
Use the Asset Correlation Tool to check how similar two investments are. It's totally free, don't worry. I love the tool!
Correlation isn't always a bad thing, and I encourage you to read my full article before deciding how it impacts your investments.
#3 way to lose money in the stock market? Invest in assets that are closely correlated or in similar sectors on accident!
There are, of course, many ways to lose money in the stock market. This list is definitely not comprehensive.
I wanted to take a more creative look at some of the commonly overlooked or misunderstood areas of investment.
Many of these can be used to earn money just as much as they can be used to lose money. Mostly the killer is when the investor (you) fails to recognize one or more these aspects at work inside their portfolio.
Understand them, learn to love them, and use them to your advantage.