Time and again, the stock market has proved to be one of the best creators of wealth over the long term. Based on historical data, and including dividend reinvestment, the stock market tends to return about 7% per year. In theory, this gives investors a chance to double their money about once every decade, which can come in handy if you're trying to retire by your 50s, 60s, or 70s.
Unfortunately, losing money in the stock market can be even easier than making it. Whether it's a lack of investing knowledge, complete stubbornness, or perhaps a simple case of hubris, investing pitfalls are everywhere. Here are nine easy ways that a fool (lowercase "f") and his money can soon be parted.
1. Time the market for a quick trade
One of the easier ways to lose your money is to try to time the market. While timing the market may be something that can be done with some semblance of accuracy on occasion, it's veritably impossible to do over the long term.
A 20-year study of the S&P 500 conducted by J.P. Morgan Asset Management using data from Lipper between Dec. 31, 1993, and Dec. 31, 2013, showed that a buy-and-hold investor would have netted a return of more than 480%, even if holding through two of the worst stock market drops we've witnessed in generations. By contrast, if you tried to time the market and missed out on just 10 of the best days over this roughly 5,000-day period, your return was more than halved to just a 191% gain. Miss a little over 30 of the best days, and you broke even.
2. Rely solely on technical analysis
There's nothing short of a small army of investors who follow various forms of technical analysis. Also known as TA, technical analysis is the study of stock charts to determine where a company's share price will head next. The problem with TA is that it can leave an investor ignoring the most important aspect of a business -- the underlying fundamentals.
If you had been following TA, you might have been tempted to purchase Valeant Pharmaceuticals (BHC 3.16%) at around $160 in September as the company appeared to be "oversold." However, since that point we've seen numerous probes emerge regarding its pricing practices, the company has slashed its 2016 full-year forecast on two separate occasions, and it's delivered two late earnings filings, which have caused its debtors, which hold $31.3 billion in debt, to start rattling the cage. Relying solely on TA would have caused you to miss the warning signs with Valeant's underlying business model.
3. Levering up
Another easy way you can potentially kiss some, or all, of your money goodbye is to consider levering up your portfolio. When opening your brokerage account, you have the choice of making it a cash-only account or a margin account. Margin allows you the ability to borrow funds from your broker in exchange for an annual percentage that can range from a few percentage points to perhaps as high as 8% or 9% in today's environment.
The upside of levering your portfolio is that if you're right, and the stocks within your portfolio move higher, you can earn a much bigger gain than you would have if you'd solely had a cash account. The downside, though, is that if the stocks you own move against you, your losses could be magnified. Your broker may also require additional funds if your account equity dips too low while using margin. If you don't have the funds available, your broker can sell stock in your portfolio at its discretion to meet the equity level required to maintain the remainder of your margin position.
4. Short-sell a stock without understanding the risks
The stock market is a two-way street, and stocks seemingly have just as much of a chance to rise as fall, which means there very well could be benefits to shorting a stock, or, in layman's terms, betting against a stock. However, if you don't understand the risks behind short-selling, you could easily lose money.
For example, gains from shorting a stock are capped at 100%, whereas your losses are infinite (since a stock can keep going up). This means you can lose more than you've initially "invested" when shorting a stock. Also, you'll need a margin account when shorting a stock, meaning you're paying interest on your bet against a company. Don't forget that some securities (usually those with high short interest) may also be hard to borrow against, meaning your broker could tag you for an additional interest rate as well.
5. Buy a penny stock
Buying penny stocks can be another way to watch your money disappear. This isn't to say that all penny stocks are bad, but as a whole, penny stocks are far more likely to lose you money than make you money.
One reason is that penny stocks aren't always listed on reputable exchanges such as the NYSE or Nasdaq. The over-the-counter stock exchanges have gone through great lengths to improve listing practices over the past couple of years, but that still doesn't guarantee you can get up-to-date financial statements from the companies you're researching. Also, penny stocks are usually cheap for a reason, with that reason usually being that they're losing money.
6. Chase a hot trend
Chasing the next hot trend is another way you could potentially lose money. Chasing the newest technology trend or consumer fad doesn't guarantee that you'll lose money, but emotions tend to run high when new products or services are introduced -- and emotional investing is a good way for a company's valuation to get way ahead of itself.
As a whole, investors are often right when they spot a new technology or service that could become big, but they're typically many years early. Some examples would include investors who piled into genomics companies in the late 1990s and early 2000s and the 3D printing craze over the past couple of years. 3D printing is likely to be transformative down the road, but investors were simply too overzealous following the introduction of the technology.
7. Being too stubborn to sell
Hubris can be another portfolio killer, and it's by far the easiest way I lose money in my personal portfolio.
Put plainly, we're all going to be wrong on an investment at some point in the future. Motley Fool co-founder David Gardner has suggested that even the best stock pickers in the world are only going to be right about 60% of the time. The key is ensuring that our money-losing investments don't wreck our portfolio.
An example I can look back on is Tower Group, a property and casualty insurer I owned shares of that operated in the Northeast. Tower wound up reporting a massive shortfall in its loss reserves in September 2013 and subsequently needed to raise cash. It wound up diluting its investors badly, and its credit ratings took a huge hit, which severely constrained its ability to underwrite new policies. Rather than selling and realizing that my investment thesis had changed, I was too stubborn and prideful to take the loss. Long story short, the stock fell another 25% from this point before I finally caved in and sold.
8. Buy options without understanding the risks
For savvy investors, options can be a great way to hedge against upside or downside in the stock market. For the novice investor, an options contract may be a ticking time bomb.
Options are contracts that allow you to purchase 100 shares of stock at a fixed price (the strike price) within a certain timeframe. The options contract holder has the choice of either executing the option and buying shares at the strike price, or the holder could simply trade the options contract and try to net a profit based on the underlying value of the contract plus the time premium involved. (This premium disappears as you near the expiration date of the contract.)
Unfortunately, the vast majority of options contracts will expire worthless. If you're thinking about buying naked options -- trading options contracts without owning the underlying security -- you're really playing with fire. If you don't understand options, you can easily get burned.
9. Put your eggs in one basket
Last, but not least, throwing all of your money, or nearly all of your money, into a single stock can be a death knell for your portfolio. No one is saying you have to go out and buy 260 stocks like a mutual fund to maintain diversification, but betting most of your portfolio on one stock can be a risky proposition.
For instance, small-cap biotech Geron (GERN 3.03%) is a company that I've had high on my watchlist for months. It's developing imetelstat, an experimental treatment for myelofibrosis and myelodysplastic syndromes, in collaboration with Johnson & Johnson (JNJ 0.06%), which has dangled a collaborative benefit worth up to $935 million if imetelstat is wildly successful. If imetelstat hits its marks in late-stage studies, it'll probably become the standard of care for myelofibrosis.
However, Geron really doesn't have much of anything in the pipeline beyond imetelstat. If I bet the farm on Geron and imetelstat hits the mark, everything is great. But if imetelstat misses the mark in phase 3 studies, it could easily lose more than half to three-quarters of its value in a day. That's not ideal, and it's why you shouldn't bet too heavily on any single stock.