Is It Possible to Lose Money in the Stock Market? Yes, but..

Is it possible to lose part all your money in the stock market? Yes, but it generally takes making one or more  poor decisions.  The good news is investors have control over these decisions and do not have to make them.

More than once, actually several times over the years, a client who was at least partially invested in a stock mutual fund or equity ETF during a declining stock market would say, "I want to sell before I lose all my money".   I would often replay, "In my estimation, the only way you will lose all your money in a stock fund fund or ETF is if all the companies in the fund go bankrupt at the same.  If this were to happen, it is likely our economy has serious long term problems and possibly headed to bankruptcy.   It is also likely many other types of investments will have no market value either.  

In retrospect, that may have not been very reassuring, but I would suggest it is true. 

Think of it this way, if there are 100 stocks in a mutual fund or ETF, and the market value of the fund goes to zero, that means 100 companies went bankrupt at the same time.  It is very unlikely for that to happen unless there is serious and long term problems with the US economy affecting and probably leading to bankruptcy for a large number of companies. If companies or businesses are collapsing at this rate, it will ripple through the economy. Smaller non-public businesses will also fail, unemployment will likely sky-rocket, government revenue from taxes will be substantially reduced, and there is likely to be a run on the banks not to mention the end of many if not most safety nets.  

If this sounds very grim, it is.  Many would argue we got very close to this in 2008 and without the government bailout, the above grim scenario may have played out.   

One reason people invest in the stock market is they assume the US economy and/or global economy are not going to completely collapse.  Contract [recession] yes, but not completely collapse.  

A second reason, is investors assume they are going to obtain a return from the stock market which is higher than other types of investments including minimal risk investments such as money market, short-term CD's, and short-term bond funds along with a variety of types of bonds or bond funds.  For example, a mutual fund or ETF which tracked the S&P Index had an average annual return of over 10% per year from 1990 thru 2017.  

This sounds pretty easy, make an investment in the stock market and watch it grow.  So why do investors lose money in the stock market.  I would suggest primarily three reasons, all of which can be avoided.  

  1. Being too narrow in investment selection.
  2. Leveraging.
  3. Being silly or selling during a decline for emotional reasons.  

Let's look at these three reasons.

Being Too Narrow
Being too narrow is simply being solely or primarily invested in one holding.  Easy examples are Enron which was an energy company whose stock fell from $90 per share to $1 per share in about a year and eventually went bankrupt in 2001.  At that time, I ready many stories about many investors who had done so well with the stock over the preceding years making it eventually their only holding.  Another example is Lehman Brothers in 2008.  If either of these stocks had been a small percentage of a portfolio, they may have caused a little pain at the time, but would not affected long term financial security.  However, if either stock was either a sole holding or large percentage of a portfolio, especially for an investor who was approaching or in retirement, the investor may never have recovered.  

I would suggest the same is true for being primarily or solely invested in one mutual fund or ETF that tracks or is tied to one specific index or asset class.  

The solution is to be be diversified in one's investment portfolio with a wide variety of holding representing various asset classes.

Leveraging or borrowing against one's investment account [it's called a margin account] to increase returns can lead to greater gains, but can also lead to significant losses including the total investment.  The initial margin or loan is 50% of the account.  So far example, an initial investment of $50,000 could be margined for a total investment of $100,000 of which 50% initially is a loan.  At this time, it is important to understand large institutional investors, especially hedge funds, will margin millions of dollars at a time, often on one specific type of investment.  

  • If the investment account grows an the investor sells, the investor will realized greater profits after paying off the loan compared to an investor who made the same initial investment, but did not margin.  However, if the investment account declines, the investor must maintain a minimum margin amount, 75% by federal law, and if the account equity to total account value becomes less then this, the investor will receive a margin call which requires the investor to either add cash to the account reducing the debt to equity ratio or account holdings will be sold to do the same.  If the account keeps declining, this process will continue until the account balance is zero.
  • During the crash of 2008, a significant amount of the rapid decline was caused by both individual and institutional investors, especially hedge funds, which had leveraged millions of dollars.   When the stock market declined, they were forced to sell stock to meet margin calls which accelerated the decline.  

The easy answer here is simply not to leverage or margin one's investment accounts to enhance the return. 

Being silly or selling into a decline for emotional uneducated reasons.
It would seem to be simply logical that investors should try to buy low and sell at a higher price in the future.  The reality is much difference.  There have been a number of studies regarding the underperformance of the average investor compared to overall market performance over an extended period of time.  Most come to the same conclusion, during a decline in the stock market, the average investor often makes emotional [sometimes in full panic model] uninformed investment decisions.  

In a perfect world, an investor would make an investment, it would increase in value every quarter and the investor would sell in the future at a nice profit.  The world is seldom, if ever, perfect in any sense including investment. Investments decline in market value daily, monthly, quarterly, annually and even longer.  Often investors react to these declines by selling their holdings.   

Continuing with above example of a mutual fund or ETF that tracks the S&P Index, though it is true these funds had an average annualized return of about 10% from 1990-2017, it also true there were significant declines during these time periods, most notably from 2000-2002 and 2008 into 2009.  At each time and historically during other declines the S&P recovered, however many investors lost money by simply selling during the decline.  [It is important to note, though there is never a guarantee for the future, each time the S&P Index declined, it eventually recovered.]  

I would suggest this is true historically for most equity asset classes.  Specifically, after a decline they have recovered to previous highs.  This is important because investors often compare their current gain or loss [unrealized] to another asset class which has increased during the stated time period.  The investor sells the current investment at a loss and reinvests in an asset class which is doing well.  Over the next time period the asset class in which they are now invested declines because it had reached its high and was ready for a correction whereas the investment they had owned recovers and eventually reaches new highs.  In the scenario, the investor loses twice, selling the first investment at a loss to transfer into the second and then selling the second after it also declines.  

The solution, do not make emotional uninformed selling decisions during a stock market decline.  Always understand the only time an investor makes or losses money on any investment, is when it is sold.  

In summary, I would suggest there are three primary reasons for losing money in the stock market and they can be avoided.

  • Be diversified.
  • Do not leverage or margin.
  • Do not sell into a decline for emotional uninformed reasons.