Making money may be tough, but in today's consumer-centric world, losing money is shockingly easy.
One need only look so far as the lottery to fully grasp just how poor Americans' money management skills can be when put to the test. A study conducted in 2011 by economists at Vanderbilt University, the University of Kentucky, and the University of Pittsburgh tracked 35,000 people who had won up to $150,000 in a Florida lottery. The findings? Winners both big and small were likely to be bankrupt in three to five years. In most cases, hitting the jackpot did nothing to reduce their odds of going broke.
I wish I could say that poor money-management skills ended with people who have won the lottery, but that isn't the case. The reality is that there are a number of simple ways to lose all your money, and what we have to do as investors is ensure that we don't get tempted by these black holes of wealth.
Here are three common ways investors can easily lose all of their capital.
No. 1: Buying penny stocks
The numbers vary widely, but the story always ends the same: More penny stock traders lose money than make money.
Penny stocks can admittedly have a strong allure. Being unable to disassociate the value of a company from its share price, investors may wrongly believe that buying more shares of a company can give them a better chance of making money. For example, buying 100 shares of a $1 stock may seem a better deal than buying one share of a $100 stock -- a dangerously misguided notion.
The truth is that penny stocks are hazardous to your wealth. Many trade on over-the-counter exchanges or the pink sheets, where regulations on disclosing events are significantly more lax. In other words, it can be difficult to find out some of the most rudimentary facts and statistics about pink sheet companies -- for example, what they do and how they performed in the latest quarter. Some penny stocks aren't even required by the Securities and Exchange Commission to disclose their earnings on a quarterly basis, making it difficult to know how well or poorly a company is doing.
How do I know so much about penny stocks, you ask? The truth is that I've been burned by them before.
In 2010 I "invested" in a developer of mobile games and apps -- which, if you recall, was quite the craze then. The company, Artificial Life, was making money and showed plenty of potential to deliver what consumers wanted in mobile gaming.
And then this happened...
Out of the blue, the company announced that it was going to abandon its mobile app business in favor of becoming a venture capital incubator for the mobile industry. As you can tell, that hasn't gone very well. To boot, once Artificial Life was kicked to the pink sheets, it was no longer required to file quarterly reports with the SEC, making it impossible to tell how the company is doing.
Put simply, if you're going to invest in penny stocks, be willing to lose all of your money.
No. 2: Putting all your eggs in one basket
Another easy way to lose all of your invested capital is to throw diversification out the window and put all of your eggs in one basket.
One thing to keep in mind is that everyone's investing situation is unique. Someone with an investment account valued at $5,000 will have less flexibility than someone working with $500,000. Even so, throwing a substantial portion of your funds into one security, or even a single sector, can be a dangerous move that could cost you all of your cash. This means investors, regardless of their account value, always need to think about ways to diversify their investments.
Need a good example? How about the unfortunate investors of GT Advanced Technologies (OTC:GTATQ) this past week.
GT Advanced Technologies is a primary supplier of scratch-resistant sapphire crystal for Apple's (NASDAQ:AAPL) iPhone. And with Apple selling nearly 79 million iPhones over just the past two quarters, the expectation was that GTAT was doing exceptionally well. However, GTAT was surprisingly left out of the iPhone 6's design -- primarily a result of GTAT's slow manufacturing capabilities. This, coupled with GTAT's poorly structured payment agreement with Apple, caused the company to unexpectedly seek protection under chapter 11 bankruptcy just weeks after Apple unveiled its redesigned iPhone 6.
Admittedly, it's rare when a company valued at more than $1 billion up and declares bankruptcy, but given that GTAT leveraged nearly all of its success to the iPhone, it effectively threw the idea of diversification out the window and doomed its shareholders.
The lesson here is that no matter how small your investment portfolio, it's always a smart idea to diversify your holdings.
No. 3: Thinking that material things are more valuable than time
The final investing faux pas that could cause your money to vanish before your eyes is attributing more value to stuff than to time.
The perfect example here would be our lottery winners mentioned earlier. Why do so many lottery winners go broke (aside from the fact that they had poor money-management skills to begin with)? A lot of their failures can be tied to an attraction to physical things like cars and clothing instead of investments that could help grow their nest egg over time. Is it wrong to buy yourself a car or clothing? Not necessarily, so long as it doesn't detract from what should be your ultimate goal of a comfortable retirement.
Perhaps Warren Buffett said it best: "The rich invest in time, the poor invest in money." It's possible that a rare car or unique home could appreciate over time, but the odds are generally quite slim. Instead, most lottery winners end up buying things, rather than investing their winnings, and thus they go broke within a few years.
Investors would be better served by using time as their greatest ally and investing in great businesses, which can allow their gains to compound over the long term. Compounding gains are what investment mogul Warren Buffett has used to accumulate his wealth, and it's no secret that you can do the same to potentially secure a comfortable retirement for yourself.