3 Ways to Lose All of Your Money in the Stock Market

The stock market is just about the best way to build significant wealth over long periods. Still, it's not without some dangers, especially for new or naive investors. Spend some time learning about how you might lose a lot of money in the stock market, and your portfolio will likely fare better.

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Avoiding losing money in the stock market is a critically important topic, and it's one I've addressed before. Just a few months ago, for example, I warned of the dangers in day-trading, penny stocks, and shorting stocks. Here are three more ways you can lose a lot of money in stocks.

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Frequent trading

One good way to lose your shirt in the stock market is to trade very frequently. It can happen if you buy every exciting stock you read about and frequently have to sell out of some in order to buy into others. That reflects a lack of confidence, patience, and discipline -- three factors that are helpful in investing success. After all, if a stock was promising enough for you to buy shares, you should give it time to perform -- and in many cases, that can be years.

According to an academic study of frequent traders by Brad Barber and Terrance Odean, the most active traders reaped the lowest returns. Indeed, between 1992 and 2006, fully 80% of active traders lost money and "only 1% of them could be called predictably profitable."

Part of the problem with frequent trading is that you can rack up hefty commission costs. If you trade 10 times per day and pay a seemingly reasonable $10 fee each time, over the course of about 250 trading days during the year, you'll pay $25,000 in fees! Making matters worse is that on the trades that actually result in a gain, you'll pay a steep tax rate. The capital gains tax rate on short-term investments (those held a year or less) is the same as your income tax rate, which is 25% for most of us and 28% and higher for higher earners. On long-term capital gains, though (from assets held for more than a year), most of us will face a tax hit of just 15%. 

The table below shows how meaningful these differences can be:

Chart by author.

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Investing with borrowed money

Another danger is investing with borrowed money -- i.e., using "margin." Buying stocks "on margin" is perfectly legal and not infrequently done, but it can be risky. Its appeal is that it can greatly amplify your gains -- but it can amplify your losses, too.

For starters, brokerages charge you interest to use margin. At one major brokerage, for example, the recent rates ranged from 6.50% if you borrowed a million dollars or more to 9.25% if you borrowed less than $10,000.

How much can you borrow? Up to 50% of the price of the securities you buy. So if you hold $100,000 of assets in your margin-qualified brokerage account, you can borrow up to $100,000, giving you total buying power of $200,000. The equity in your account is the collateral that you're putting up for the loan. If the value of your investments starts falling significantly, you'll get a "margin call" from your broker, asking you to sell some assets to generate cash, or to deposit more cash into your account. If you fail to do so, the brokerage may just sell some of your holdings for you. (Interestingly, the 50% limit hasn't always been in place. Investors could borrow much more than that decades ago, which is one of the reasons that so many investors were wiped out after the 1929 stock market crash.)

If you invest on margin, you can lose more than you invested. If you borrow a lot for a long period, you'll accumulate significant interest costs, too.

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Following the herd

Finally, beware of following the herd when you invest. That can happen if you're making investment decisions based on fear or greed. Imagine, for example, that the stock market crashes to some degree, taking down the prices of gobs of stocks and suddenly shrinking the value of your portfolio. That happens -- and often gets worse -- when lots of people start selling. The more they sell, the more prices drop. And you, if you're acting on fear, will sell, too -- either locking in a loss or a smaller gain, while parking yourself on the sidelines for the eventual recovery. Whenever there's a downturn in one or more of your holdings, do some digging before selling. Find out if there's a lasting problem or just a temporary one. Ride the temporary ones out.

Meanwhile, if you're drooling over some high-flying stocks, know that they're flying high because many people are excited about them and snapping up shares, sending the share price up. That's when greed can have you jumping on the bandwagon, too -- no matter whether the stock is actually overvalued now or undervalued. (Highfliers have often surpassed reasonable valuation levels and can be more likely to fall than rise in the near term.)

It's smart to have an overall investment plan, such as long-term value investing -- where you seek out undervalued stocks and hang on. Remember the wise words of superinvestor Warren Buffett, who said, "Be fearful when others are greedy, and greedy when others are fearful."

Avoid the blunders above and you'll likely make fewer investing mistakes while enjoying bigger returns.