I’ve written before about day trading, and how it’s one of the easiest ways to lose all of your money in the stock market. After all, many active day traders need to earn six-figure trading profits just to break even.
However, we’ll assume that you aren’t an aspiring day trader. Even if you invest for the long haul, there are several ways you could potentially lose your money in the stock market. Here are three particularly bad mistakes to avoid.
1. Chase the next big thing…with all of your money
Bear with me — I’m going to pick on one of my least-favorite stocks right now. Simply put, I would never invest in Snap, Inc. (NYSE:SNAP), and it appears that most analysts agree with me. Without getting into a long justification, let’s just say that I don’t like the business’s fundamentals, and I just can’t bring myself to invest in a company that says it may never be profitable. Having said that, I also wouldn’t have bought Amazon.com in the early 2000s, and I considered Tesla to be overvalued at $70 a share. So, if you’re a fan of Snap, take my comments with a grain of salt.
It’s fair to say that when it comes to the Next Big Thing stocks, it’s tough to say which will be successful. And that’s my point. If you want to speculate with high-potential, but as-of-yet unproven stocks like Snap, there’s absolutely nothing wrong with doing so. I personally own shares of Fitbit, a stock that I consider to be highly speculative.
It’s OK to speculate with a small amount of your capital, as long as you do it responsibly and keep most of your money in a well-diversified portfolio of rock-solid stocks and funds. In my personal example, Fitbit represents less than 1% of my total portfolio.
Don’t put all of your money into speculative stocks. You could get rich if you happen to pick the next Amazon, but you can also lose everything.
2. Invest with emotion
To be fair, this isn’t really a way you’re going to lose money. However, investing emotionally can rob your long-term gains, which can be just as bad.
Over the 30-year period from 1975 to 2014, the SP 500 has generated average total returns of about 11.1% per year. Meanwhile, the average equity fund investor has managed a paltry 3.8%, according to Dalbar. Why?
There are several reasons, but a big one is emotional investing. In a nutshell, most investors sell stocks in panic when the market plunges, and buy stocks when everything is expensive and all their friends are making money. It’s common knowledge that the general goal of investing is to buy low and sell high. Unfortunately, many investors do the exact opposite.
To illustrate why I’m such an avid buy-and-hold investor, consider this example. Let’s say that you had $20,000 to invest in 1975, and chose to invest it in a low-cost SP 500 index fund. Based on the market’s historical performance, your investment could grow to nearly $411,000 after 30 years. However, the average investor’s returns would have grown this to just $61,000.
Essentially, this is just another form of losing money. The first example was a way to lose all $20,000 right away. And this is a way to “lose” $350,000 over 30 years by not investing with the proper patience and objectivity.
3. Use options before you know what you’re doing
Options are some of the most complex financial instruments in the world, and should not be used for speculative purposes, especially if you don’t fully understand what you’re doing.
There are certainly some good uses for options in the strategies of non-professional investors. Covered call writing and put selling are two options strategies that I use from time to time to boost my returns and hedge against market drops. Even basic strategies like these shouldn’t be used without a thorough knowledge of how they work and the time commitment required to use them correctly.
Where novice investors get into trouble is by treating options like lottery tickets. I’m talking about buying out-of-the-money calls in the hopes that the stock price rises, or buying out-of-the-money puts to bet against a stock. While this can be incredibly lucrative if the trade goes your way, the opposite outcome is far more likely — just like when you play the lottery.