Some stock market moves are more like gambling than investing. Photo: Zdenko Zivkovic, Flickr
Most of us know that buying lottery tickets should be done in moderation, if at all, and for entertainment or speculation only. The odds of winning any meaningful sum are astronomically prohibitive.
You'd be right to think about investing in the stock market instead, which is a much more promising way to build wealth. After all, over many decades, it has averaged annual gains of close to 10%, and has trounced investments in bonds, real estate, and other alternatives.
But even the stock market has risks to be wary of. Here are three ways you can lose all your money -- or the vast majority of it -- in the stock market.
Todd Campbell: Stock options can deliver eye-popping returns, but because options expire on a specific date, and markets are unpredictable, they're extremely risky. Stock options allow you to buy (calls) or sell (puts) on a specified number of shares in a company at a set price on or before a particular date. In exchange for this right, investors pay a premium that varies day to day based on whether the stock is up or down, and how much time remains before the expiration date of the option.
Imagine a stock trading for $17 per share. If an investor buys a call to buy shares of that stock for $20, and that stock surges to $30, then the investor can exercise his or her right, buy the stock, and make a nice profit ($30 minus whatever premium was paid). But if that stock falls to $10, the option expires worthless, and the investor loses the entire premium that was paid upfront.
Options aren't inherently bad, and certain strategies are used by pros to generate income; but jumping in, and overcommitting to options without understanding their risk is a recipe for a wipeout.
Photo: TaxCredits.net, Flickr.
Selena Maranjian: A very-efficient way to lose all your money in the stock market is to engage in day trading. Day traders are people who rush in and out of lots of stock holdings frequently, often holding a security for a few hours, or minutes, or seconds as they hope to make a quick profit on a move in the security's price. They aim to make a lot of money on volume, by racking up gobs of small gains over time.
That's not really investing -- it's gambling. And it's quite different from the way that Warren Buffett and others made their millions or billions in the stock market.
A good way to become wealthy through stocks is to study companies, and buy stock in the best ones when they're priced attractively -- and then to hang on for many years, as long as the companies are healthy and growing.
Day traders face many headwinds, such as the fact that they're really just guessing about which way a given stock will move in the very short term. Because they often place dozens, or even hundreds, of trades in a single day, they face steep commission costs from those trades. And any gains they reap will face short-term capital gains taxes, which are the same as their ordinary income tax rates -- 25% or 28% for most folks, and even more for high earners.
Don't just take my word for it, though. Consider the words of the Securities and Exchange Commission (SEC) itself, which explicitly warns against day trading, saying things such as:
Be prepared to suffer severe financial losses. Day traders typically suffer severe financial losses in their first months of trading, and many never graduate to profit-making status.
Day trading is an extremely stressful and expensive full-time job.
Don't believe claims of easy profits.
Photo: Jonathan Rolande, House Buy Fast.
George Budwell: In my experience, one of the quickest and easiest ways to lose all of your capital is by buying clinical-stage biotech stocks that are far too dependent for success on a single experimental product candidate. These types of companies tend to be dilution machines that crush long-term shareholder value. On top of that, the vast majority of binary events -- such as pivotal clinical or regulatory catalysts -- go against shareholders, resulting in devastating losses.
Sarepta Therapeutics (SRPT 2.53%)is a prime example of this phenomenon. The company has now seen its share price dive by more than 50% twice in a single day, all because of its experimental Duchenne muscular dystrophy treatment called "eteplirsen." Without going into too much detail, the FDA initially decided not to review the drug on an accelerated basis in 2013; then, earlier this month, the agency basically stated that it's not particularly impressed with eteplirsen's limited clinical profile -- presumably sinking its chances of an accelerated approval in this review cycle.
If eteplirsen doesn't somehow pull a miracle off during its upcoming review with the FDA, investors are most likely facing at least three years' worth of secondary stock offerings that will dilute the value of all shares, a dwindling share price, and an uncertain outcome regarding the drug's ongoing late-stage study. Under those dire circumstances, it's not hard to see how shareholders who got caught in the stock's most-recent downturn could end up losing the bulk of their original investments. After all, that's not an uncommon storyline among clinical-stage biotechs, in general, especially those with particularly thin pipelines, like Sarepta.
Now that you know how not to lose money in the stock market, how can you best build wealth in it? You can read broadly and learn to select very promising individual stocks. Or you can find solid mutual funds with low fees and skilled managers. Or you can just stick with low-cost, broad-market index funds, as they require little attention, and tend to outperform most managed mutual funds, too.
Some portfolio contenders are the SPDR S&P 500 ETF (SPY -0.38%), Vanguard Total Stock Market ETF (VTI -0.47%), or Vanguard Total World Stock ETF (VT -0.32%). Respectively, they will distribute your assets across 80% of the U.S. market, the entire U.S. market, or just about all of the world's stock market.
