There’s no question or debate about it. Investing in the stock market has helped investors grow their wealth for hundreds of years now.
But just because you invest in stocks doesn’t mean you’ll become wealthy. In fact, investing in the stock market is a complex business that comes with significant risks.
So, can you lose money in stocks? The short answer is absolutely, but let’s explore in great detail how this is a possibility.
How do people lose money in the stock market?
Before we unpack how people lose money in the stock market, let’s first understand the basic principle of investing. In general, investing entails the speculation that an asset will increase in value over time. In this example, the asset is the stock of a company.
However, there is absolutely no guarantee that the stock will actually increase. For example, imagine you decide to buy 100 shares of stock ABC at a purchase price of $85 per share. Your initial investment would be $8,500 as a result of multiplying 100 shares by $85.
You purchased this stock under the belief that the value of the stock would increase to $125 over the next two years. However, fast forward 24 months later and the price per share declined to $35 per share, which is a loss of $50 per share.
So, you initially invested $8,500 to purchase 100 shares, but at the new market price, your asset is only worth $3,500. If you were to sell your shares at a price of $35 per share, you would experience a loss of $5,000.
If you don’t sell, the price per share could either continue to decline or rise in value over time. But nonetheless, even if the price did in fact rise, it would need to rise significantly to offset the initial decline.
Can you go into debt with stocks?
It’s important to note that you cannot go into debt as a result of investing in stocks unless you borrow money against your portfolio. Various brokerages provide their clients with leverage, which is also known as margin. This essentially multiplies the amount of money that the investor is able to invest.
For example, if you have $10,000 in your brokerage and your brokerage provides you with two-to-one leverage, you’d have $20,000 that you can invest. However, the additional $10,000 that was provided by your brokerage is borrowed money.
If you lose that money, you will need to pay it back somehow in addition to any interest that the brokerage charges. Investing with leverage can multiply your purchasing power, but it can also multiply your risk exposure. Generally speaking, only professional investors or traders should consider investing with borrowed money.
If a stock goes negative, do you owe money?
If you do not use borrowed money, you will never owe money with your stock investments. Stocks can only drop to $0.00 per share, meaning you can lose 100% of your investment but not more than that, seeing as the stock cannot be of negative value.
Cash vs margin account
There are two main types of brokerage accounts. The first type of account is known as a cash account. There is no question that cash accounts provide the investor with more safety.
The money in this type of account is the money you’ve deposited and nothing more but also nothing less. You can lose 100% of your investment, but you will not go into debt when you trade or invest the money in a cash account.
The second type of account is a margin account. There is not a one-size-fits-all margin account either. Some brokerages offer a two-to-one margin account, whereas other brokerages offer three-to-one, four-to-one and even five-to-one margin accounts.
The first number is the multiplying number. You can multiply your purchasing power by borrowing multiplied intervals of the cash value of your portfolio.
Again, it’s essential to understand that borrowing money that you can invest in the stock market exacerbates your risk exposure. But even with the increased risk, margin accounts are popular as they also multiply your gains when you make a good trade or investment.
Tips to minimize risks when investing in stocks
Investing in the stock market is risky, and you should certainly do your research before making any investments. With that said, there are ways to minimize your risk, which is often referred to as risk management.
Don’t invest more than you can afford to lose
The first rule should be to never invest more than you can afford to lose. Investing is very emotional as no one wants to see their assets decline in value and no one wants to lose money.
But the emotions can become even more overwhelming when you’re investing money that you actually need so that you can pay your bills. While losing money is never the desired outcome, only invest what you can afford to lose.
Always be sure to diversify
Another way to reduce your risk exposure is to diversify your investments. If you plan to invest $10,000 into stocks, divide that total investment amount by four or five. Then, invest those four or five subsets into separate stocks.
In doing so, you won’t find yourself allocating more than 25% of your total investment towards any single stock. If one stock declines in value, you will still have three or four other stocks that could rise in value. Investing in ETFs is another great way to add diversification to your portfolio.
ETFs stands for exchange-traded funds. They essentially aggregate many different companies into one investment vehicle. For example, you can purchase the SPY ETF, which is a portion of all 500 companies in the S&P 500.
Understand the different types of accounts
Make sure you know what type of account you should use before you open anything. As mentioned above, there are cash accounts and margin accounts. If you want to reduce your risk, stick to a cash account rather than a margin account.
Beyond that, you need to decide which assets you’ll invest in. Do you want to trade individual stocks, currencies or options? Options trading comes with increased risks, but some people consider the increased risk to be worth it considering the benefits options trading can yield.
Play the long game
Timing the market entails figuring out exactly when the perfect time is to purchase stocks. This is incredibly complex and challenging to figure out. People lose a lot of money trying to time the market, but instead of timing the market, you should spend time in the market.
Play the long game. Buy stocks from companies that you envision existing and dominating their class for the next five, 10 or even 20 years. This value-based investing mentality is Warren Buffett’s claim to fame.
Know your exit strategy
Another critical variable you need to be aware of is your exit point. This is the point at which you will no longer engage in a stock if it rises or falls to a specific value.
Holding onto losses may further add to your overall loss. Choosing not to sell when a stock rises in value may leave a lot of money on the table if, in fact, the stock pulls back.
Before you purchase a stock, you should predefine what your sale price will be if the stock rises or falls in value. For example, if you buy a stock for $100 per share, you may choose to sell your shares if the price reaches either $90 per share or $125 per share.
Make sure you stick to whatever plan you make no matter how challenging it may be in the moment. No one wants to lose money in stocks, but cutting your losses early is often the best thing you can do to minimize your risk exposure.
Tips to minimize risks in margin accounts
If you’re willing to take on the extra risk of using a margin account, be smart about it. There are ways to minimize the risk of your margin account.
Leave some cash in your account
Always leave cash in your account, and never invest 100% of what you borrowed or your entire portfolio value. Leaving cash in the account will help you avoid having a margin call on your account, which may cause you to sell stocks at a bad time just to satisfy your brokerage obligations.
Pay interest regularly
Brokerages charge interest when you borrow their money, and interest can become very expensive. Make consistent interest payments to avoid the possibility that debt piles up. Keep in mind that, for a margin-based trade or investment to be worthwhile, the return you see in the stock needs to exceed the cost of borrowing money from the brokerage.
Understand your limits
As mentioned above, you need to know your exit point. This cannot be stressed enough. Having an exit plan when circ*mstances go poorly will keep your account alive. As such, do not become stubborn or greedy with your investments.
Remember that it is perfectly okay to admit you are wrong and then choose to sell your shares. You’ll never be 100% right all the time, but to be successful in the world of investing, you’ll need to generate more money when you’re right to offset the money you lose when you’re wrong.
Invest as a way of reaching your financial goals
Losing money in stocks is never the goal. People invest in the stock market to watch their money and investments grow over time.
Undoubtedly, the stock market has helped people create wealth and additional income. Historically, investing has provided a return above and beyond the yearly inflation rate. Investing comes with risks, but that doesn’t mean you shouldn’t try it.
You just need to do your homework and research before deciding which stocks to purchase. A few great investments may be all you need to reach your financial goals.
FAQ
Do I owe money if my stock goes down?
If the value of your stock decreases, you will not owe money. You will only owe money on stocks if you used borrowed money to purchase them and they happened to decrease in value.
Can you lose more money than you put in stocks?
The only way you lose more money than you initially invested is if you used borrowed money to make the purchase.
How do you recover lost money in the stock market?
To recover any money you lose in the stock market, you’ll need to buy assets and stocks that appreciate in value following the initial purchase.
As someone deeply immersed in the world of financial markets and investing, it's evident that the complexities of stock market dynamics are often underestimated by those who approach it casually. My experience and expertise in this field, gained through years of active involvement and continuous learning, allow me to delve into the nuances of investing with a profound understanding.
Let's break down the key concepts discussed in the provided article:
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Risk in Stock Market Investments:
- The article rightly emphasizes that investing in stocks is not a guaranteed path to wealth. Despite its historical track record of wealth creation, the stock market involves inherent risks that can lead to financial losses.
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Factors Leading to Losses:
- The primary factor contributing to losses is the unpredictability of stock prices. The article illustrates this with an example where an investor purchases stock expecting it to rise but faces a significant loss when its value declines instead.
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Debt and Stocks:
- The article clarifies that, unless you use borrowed money (margin), your stock investments cannot put you into debt. It highlights the concept of leverage, cautioning that borrowing to invest increases both potential gains and risks.
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Cash vs. Margin Accounts:
- Two types of brokerage accounts are introduced – cash accounts and margin accounts. Cash accounts provide safety as they only allow trading with deposited money, while margin accounts involve borrowing, amplifying both gains and losses.
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Diversification:
- Diversification is presented as a crucial strategy to mitigate risk. By spreading investments across different stocks or using Exchange-Traded Funds (ETFs), investors can avoid excessive exposure to the fluctuations of any single asset.
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Long-Term Investing:
- The article advocates for a long-term investment strategy, discouraging the risky practice of trying to time the market. It emphasizes the value-based investing mentality popularized by Warren Buffett.
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Exit Strategy:
- Knowing when to exit a stock is stressed as a critical aspect of risk management. Having a predefined plan for selling stocks, whether they rise or fall, helps in minimizing losses and maximizing gains.
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Minimizing Risks in Margin Accounts:
- For those using margin accounts, the article provides additional tips, such as leaving cash in the account to avoid margin calls, making regular interest payments, and understanding personal limits.
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Investing as a Goal-Oriented Activity:
- The article concludes by emphasizing that the goal of investing is not to lose money but to achieve financial objectives. It acknowledges the historical success of investing and encourages thorough research before making investment decisions.
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FAQ Section:
- The frequently asked questions cover important aspects, such as whether a decrease in stock value leads to owing money, the possibility of losing more money than invested (with borrowed funds), and the strategy for recovering lost money in the stock market.
In summary, the article provides a comprehensive overview of the risks associated with investing in the stock market, accompanied by practical tips and strategies for minimizing those risks. It serves as a valuable resource for both novice and experienced investors seeking to navigate the complexities of the financial markets.
