If you're an investor, knowing what not to do can be even more important than picking the right stocks. After all, even the best stock pickers can hope to earn about 15%-20% returns each year. On the other hand, one bad move can literally wipe out your entire portfolio.
With that in mind, here are three things that you definitely don't want to do with your money, and why they are such bad ideas.
Dan Caplinger: During long bull markets like we've seen over the past six years, it's always tempting to use the leverage available from using margin debt in order to multiply your positive returns. With interest rates at extremely low levels, some brokers will offer you financing at as little as 1%-2% interest, making it easy to keep up with finance charges as long as the stock market keeps moving in the right direction. Indeed, many dividend stocks have yields that are higher than prevailing rates, making debt maintenance even easier.
The problem comes later, though, when a market correction comes. As your portfolio value falls during a bear market, your margin debt becomes a larger percentage of the value of your total investments. If that percentage gets too large, then your broker will automatically start selling assets in order to pay off the margin loan or at least reduce it to a more manageable size. Those forced sales typically come at exactly the worst time, when shares have already lost considerable value -- and before any potential rebound.
Investing on margin always involves some risk, but the key is to make sure you don't get overleveraged. Like many things, using margin loans in moderation isn't a problem, but getting hooked on them can leave you penniless faster than you'd imagine.
Jordan Wathen: I can think of no better way to lose money than to take a stock tip from anyone without doing your own due diligence.
The simple fact is that people buy stocks for any reason, some good, and some bad. Without proper investigation on your own, you may be buying companies that are vastly different than what they appear to be. Altria (NYSE:MO) is known as a tobacco company, but it also has a growing alcohol business. Disney (NYSE:DIS) is known for Mickey Mouse, but ESPN is increasingly becoming its "bread and butter," so to speak. CarMax (NYSE:KMX) is a car dealership, but behind it is a hidden car auction business. These are all vastly different businesses than they appear to be.
Doing your own due diligence is paramount to understanding the factors that make a stock worth buying or selling. Never take a stock tip at face value without investigating it on your own.
Matt Frankel: One effective way to lose your money is to start buying out-of-the-money options, which is about as much of a lottery ticket as you can buy.
Now, there are some responsible uses of OTM options. For example, if I have a large short position in a certain stock, I could buy a few OTM calls as a hedge against a rapid price increase, thereby capping my potential losses.
However, one common "rookie mistake" is to buy a large chunk of OTM calls or puts as a speculative investment in order to receive a big payday. For example, Citigroup (NYSE:C) is trading at about $49 per share as of this writing, and the January 2016 $60 calls are trading for about $1.10.
So, if Citigroup has a phenomenal year in 2015 and shoots up to $70 before expiration, you'll make nearly 10 times your original investment. However, the much more likely scenario is that your contracts will still be out of the money at expiration, and therefore worthless.
Options can be an excellent investment tool when used responsibly by investors who know what they're doing. However, when used the wrong way they are a good way to lose all of your money rather quickly.
Dan Caplinger owns shares of Walt Disney. Jordan Wathen has no position in any stocks mentioned. Matthew Frankel has no position in any stocks mentioned. The Motley Fool recommends CarMax and Walt Disney. The Motley Fool owns shares of CarMax, Citigroup Inc, and Walt Disney. 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.