When you work hard for your money the last thing you want to have happen is your savings disappear into a bad investment. While this concern is healthy, its important to have a realistic understanding of market risks and what can and cannot happen.
You may have heard people say “I lost all my money on the stock market”. Maybe you’ve heard news reports of banks, hedge funds or insurance companies going completely bankrupt due to “bad investments”. You might be thinking “if they can’t survive in the markets, what chance do I have?” But this would be the wrong conclusion, as an individual investor you can completely avoid the causes of these financial “blow ups”.
How to Never “Lose All your Money” on the Stock Market
When large financial institutions or wealthy individuals “blow up” (go bankrupt), it is usually due to a combination of the use of leverage (debt), short positions (with unlimited loss potential) and financial derivatives. When you mix complex trading or investment strategies with lots of debt you get a recipe for disaster. Slight changes in the price of a stock could cause massive changes to portfolio value and quickly wipe out the investor.
To avoid a blow up its pretty simple:
- Don’t Use Leverage: Do not use margin in your brokerage account or take out extra debt to trade. Doing so magnifies your gains as well as your losses. This could lead to bankruptcy. Additionally, when stocks are falling you will not be able to hold through a correction because the brokerage will demand you “post collateral” meaning you will have to sell off positions early (dooming you to lock in your losses at the worst possible times).
- Don’t Short: When you short a stock you make money if its price goes down. BUT, it exposes you to unlimited losses (since a stock can only lose 100% of its value, but it can go up to an infinite price). So, even a small short position going against you can wipe out your whole portfolio (as we saw happen to several hedge funds that were short Game Stop). You will sleep better at night if you simply do not do this.
- Don't Use Financial Derivatives: Stock options, swaps, futures and other derivatives should only be traded by professionals or with advise from professionals. Similar to shorting, its possible to quickly lose your entire investment or be liable to owe more money than you are worth. One Exception: Buying put options has limited downside (only the amount you invest in them) and they act as insurance on a stock. Put options can help hedge risks. Still, avoid using them if you do not understand them or use them with the help of a professional.
- Avoid Pre-Revenue or “Penny” Stocks: Some companies will trade on exchanges but are not yet “real” businesses. Meaning they do not yet sell products to customers. Additionally, penny stocks may be very small (in terms of market value & liquidity) that large swings in price are likely. To avoid this volatility simply focus on investing in companies with a real business not in hype for the future. If you really like a new firm that is doing interesting R&D or has a future product you believe in, then investing a small amount (as % of your total portfolio) could be ok as long as the rest of your portfolio is diversified across real businesses.
Warren Buffet, the world's richest investor (worth about $100 billion) famously sums those up by saying:
If you follow those four guidelines (or just listen to Buffet) you will protect yourself from “going bust”. To further improve your results, we know from our earlier posts that we want to invest in real companies that produce products/services, revenues, profits (or have a realistic path to profitability) and trade at reasonable ratios compared to peers. If we diversify our investments into those types of quality businesses, then how could we go bankrupt? The answer is that its practically impossible.
While it is true that the stock market and economy goes up and down in cycles, and that if you happen to be investing at a peak just before a crash or correction you could quickly lose 20% to 50+% of your portfolio’s value you will still NOT go bankrupt, NOT lose “all” your money, no one will force you to sell at the lowest point and you WILL be able to recover over time. As the event that caused the crash (a recession, oil shock, war, natural disaster, pandemic etc.) is worked through by society the market will eventually recover and your diversified portfolio will survive.
Thinking About Risk When Investing Small Amounts
In our post about investing in stocks we talked about building a diversified portfolio actively by selecting 10+ individual stocks along with a few ETFs across indexes to be diversified, or as a passive investor simply selecting 4-7 ETFs that track major indexes/industries/commodities. While that should be the long term goal for any portfolio, small portfolios face unique constraints that require an adjustment.
First off, by “small amounts of money” we can generally define it in terms of how much you make and how long it would take you to replace the amount invested. If it would take less than a couple of months of work for you to earn back your investment amount then its small. For example, if you make $4,000 per month (the average in Canada) and you are just starting off then even investing $8,000 could be considered small. The higher your income the higher your definition of a “small” investment gets.
This is important because it changes how you build up your portfolio. If you had $100,000 saved and ready to invest all at once, then it would make sense to have it diversified on day one (buying index ETFs, bond ETFs, REITs, stocks, Gold, etc.) and then adding to each position over time. But, if you’re starting with say $2,000 then suddenly you can only buy 1 share of Shopify and not even 1 share of Amazon! If you tried to diversify the $2,000 portfolio, you will end up with many small $100-200 positions, that will not be meaningful and only increase your trading costs. It would make more sense to imagine how much you are planning to invest over the course of the next year or two and plan which stocks you want to hold over the long term. Then even if you only bought 1 share of Shopify (as an example) and that was 75% of your initial $2,000 portfolio, you would simply be setting your portfolio up for future diversification even if its temporarily undiversified and highly “risky”.
Hopefully, this helps illustrate some of the dynamics of portfolio risks and diversification. As we’ve said in past posts there is no one right answer when it comes to investing and if it was easy then everyone would do it full time. The key is to consistently invest in quality firms, avoid unnecessary risks and have a long term view.