The stock market giveth, and the stock market taketh away, too. True, investing in equities is one of the best ways (if not the best way) to build substantial long-term wealth, but if you don't know what you're doing, you can lose much or all of your money instead. Here are three ways to lose big in the stock market. Learn about them so that you don't make these costly mistakes.
Selena Maranjian: A great way to lose much of your money in the stock market is to invest in risky high-flyers -- or companies that you hope will be high-flyers. A lot of poor investing is based on hope, especially when it comes to penny stocks that are often tied to companies that might cure cancer or literally strike gold.
Many times, people invest in a stock without really understanding how the company makes its money, or how undervalued or overvalued it might be. You want to focus on high-quality companies that are likely to keep growing, but you also want to buy into them when they seem undervalued. If you spot a stock that has doubled or tripled in the past year or two, there's a good chance that no matter how exciting it might be to you, it's overvalued.
In recent years, some companies that have had investors excited have included Groupon and Twitter. Both have histories featuring rapid growth, but Groupon didn't have sufficient competitive advantages to keep competition at bay, and couldn't ramp up its scale without hiring lots more employees. Twitter is a major online site, with more than 300 million monthly active users. It may be able to generate great profits off such a big base, but it's not yet clear how successful it will be at that. Both companies have been largely unprofitable in recent years, and their stocks have swooned.
Excited by biotech companies, many of which have very promising drugs in trials? Be careful -- they don't all fly through trials successfully, nor earn FDA approval. IT is an especially risky industry unless you're very familiar with it.
Stick to companies with proven records of revenue and earnings growth, ideally with rising profit margins, generous free cash flow, little debt, and competitive advantages. Aim to buy them when they're undervalued, and then hang on.
Brian Feroldi: Many new investors are in a rush to make money as quickly as possible in the stock market, and decide to give day-trading a try. That may sound like an enticing way to go, but day-trading can be disastrous to your long-term returns.
Why? Well, it's impossible to know which way a stock is going to move over the short term, as there are simply too many factors at play to make an educated guess.
If you think that you have a can't-miss system for making money by day-trading, I'd encourage you to read Flash Boys by Michael Lewis. In this book, Lewis details the extreme methods that high-frequency trading firms use in order to gain an edge over other market participants. Essentially, they use complex algorithms and extremely fast computers to legally front-run other market participants. This allows them to take advantage of other traders and earn risk-less profits.
How advanced have high-frequency trading firms become at finding those edges? They now measure the speed of their trades in picoseconds, which are trillionths of a second. Do you really think you can gain an edge over a competitor like that? Besides, day-trading means making a lot of trades, which generate a lot of trading commissions for your brokerage, and cut severely into any profits you manage to accrue.
So what can individual investors do to thrive in today's market? Lewis offered up three suggestions. First, use limit orders whenever you buy or sell to ensure that you get the exact price that you want. Second, do your own research and only invest in assets that you understand. Finally, stay invested for the long term.
Attempting to make money as a day trader was an extremely difficult challenge 20 years ago, and that was before modern, super-fast computers took over. So unless you want to lose all of your money, avoid day trading like the plague. Those who day-trade are not really investors -- they're gamblers.
Matt Frankel: One of the worst things an investor can do is to misuse options in their portfolio. Specifically, buying out-of-the-money options with a large percentage of your money is not much better than simply cashing out your account and taking the money to a casino.
This is a common mistake among those new to investing -- and it's easy to see why. After all, if you're bullish on a stock, buying options closer to the price you think the stock will reach could mean mega-gains if you're right. Unfortunately, the consequences for being wrong can be catastrophic.
For example, as I write this in mid-June 2016, I think Goldman Sachs is one of the best bargains in the financial sector, trading for about $147 per share. A quick glance at Goldman's option chain tells me that I could purchase a call option to buy 100 shares of the stock at a price of $160 any time before Oct. 21, 2016, for $400 per contract (or $4.00 per share).
If Goldman Sachs climbs to $180 by the expiration date, my options will be worth $2,000 per contract, and I'll have a 400% gain. However, if the stock closes below $160, my entire investment will be lost. Even if the stock goes up to, say, $155, I'll lose all of my money.
Because of this, it's unwise to speculate on out-of-the-money options with any sum of money you'd be unwilling to wager on a hand of blackjack. The odds of success aren't much better.
For best results when investing in the stock market, take the time to learn a lot about investing and then stick with proven, high-quality companies. Aim to buy them when they're undervalued and then to hang on for many years, as long as they remain healthy and growing. If that seems like too much trouble, you can still do well sticking with a simple and inexpensive broad-market index fund, such as one based on the S&P 500.
Brian Feroldi has no position in any stocks mentioned. Matthew Frankel owns shares of Goldman Sachs and Twitter. Matthew Frankel has the following options: long January 2017 $20 calls on Twitter and long January 2017 $10 calls on Twitter. Selena Maranjian has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Twitter. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.