Learn more about these minefields so you can tread carefully around them.
By Brian Feroldi
To be a successful investor, it’s just as important to know what to do as it is to know what not to do. After all, you could be a wonderful investor and churn out market-thumping returns year after year, but if you get reckless and do something stupid, then your nest egg can disappear in a hurry.
Knowing that, we reached out to a team of Motley Fool contributors and asked them to opine on one way an investor can get wiped out in the markets. Read below to see what they said so you can avoid these minefields in the future.
Dan Caplinger: The stock market is risky enough when you stick with just owning shares of companies you choose. Where some investors get into real trouble is by ramping up the risk level of their investment portfolios by using strategies like investing on margin or using options to create leveraged plays on stocks they like.
Most brokers will let you borrow on margin in order to buy more shares of stock than you could otherwise afford. That’s great when the stock goes up, because you own more shares and therefore get bigger profits. However, the margin loan charges interest, and it’s also subject to rules that can force you to cash out at what often turns out to be the worst possible time, creating permanent losses from which you can’t recover.
Similarly, options strategies can produce huge returns when the underlying stock moves in the direction you expect within a given timeframe. However, many options expire worthless, and you can lose everything with an options portfolio even if the share prices stay stable or move slightly in your favor.
All in all, opportunities for leverage increase potential return, but they also result in higher risk. Using leverage incorrectly can dramatically increase the chances of losing everything in the stock market.
Brian Feroldi: One big way many first-time investors go wrong in the stock market is by only buying shares of penny stocks. It’s all-too-easy these days to find an “exciting” penny stock to invest in since there are advertisements all over the web that promise huge gains if you follow the promoter’s “can’t-miss” system.
Unfortunately, the real truth is that buying penny stocks is generally a very bad idea, and often, the companies that are promoting penny stocks are running a simple pump-and-dump scam. Buying the stocks they are pitching is almost guaranteed to lose you a lot of money.
Image source: Tax Credits on Flickr.
Need proof? A few years back, one of The Motley Fool’s analysts was smart enough to create a dedicated CAPS page that simply gave a thumbs down to every penny stock that he came across. The results speak for themselves — more than 93% of the penny stocks identified have drastically underperformed the markets, and several dozens of the companies on the list have produced a loss of 98% or more.
The takeaway here is clear: Avoid investing in penny stocks and put your money into quality companies or index funds instead.
I, for one, had to learn this lesson the hard way. When I first started investing, I only invested in penny stocks as I was very attracted to the idea of a low share price. At the time, I didn’t have a lot of money to invest, so I liked the idea of being able to buy hundreds or even thousands of shares with only a few hundred dollars. Besides, since the price was so low, the shares only had to go up a pennies for me to bank a strong profit, right?
Wrong. Every penny stock I bought fell drastically and my savings were quickly whittle down to next to nothing. Thankfully, I sold before things got really bad. Lesson learned: Investors should completely ignore the price of the shares that a company is trading at and focus far more of their attention on the quality of the business itself.
Selena Maranjian: A great way to lose everything in the stock market is to not have a good grip on your emotions. Greed, for example, can destroy a lot of wealth by driving you to invest in high-fliers that have already exceeded their intrinsic value and are getting too close to the sun.
And then there’s fear. If you don’t accept the fact that the stock market and individual stocks will go up and down — sometimes sharply — over time, then you may end up panicking and bailing out of stocks that experience temporary downturns. Remember that when it comes to the overall market, it has recovered and gone on to set new highs after every downturn. A graph of the stock market’s long-term performance is quite jagged, but the overall trend has been upward.
Datafrom Dalbar & Lipper has shown just how destructive our emotions can be to our wealth. Between 1996 and 2015, stock mutual funds averaged annual gains of 7.7%. That’s enough to turn a single $10,000 investment in 1996 to $44,000 by the end of 2015. Amazingly, though, the average annual gain of the average stock mutual fund investor was just 4.7% over the same period. Growing at 4.7% annually over 20 years, a $10,000 investment will become $25,000 — fully $19,000 less. Why the difference? Well, it reflects investors selling out of their funds when afraid and jumping back in when greedy. The bigger gain was realized only by those who sat put. Trading in and out of stocks or funds can also rack up commission costs and lead to short-term gains, which are generally taxed at higher rates than long-term gains.
Remember that just about every great long-term stock has dropped or stalled at some point. As long as you have faith in the underlying company, it’s often best to hang on. Being patient and rational can boost your portfolio’s performance.
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