Investor Doomsday: Why Do People Lose Money in the Stock Market?
Updated: Jun 9, 2020
While it’s no secret that The Dividend Payout wants you to start investing now, there are several key questions that you need to be asking yourself before you start.
Investing is an intricate game full of potential rewards; but there are people who have gotten in without the right resources and ultimately paid the price for it. Whether you’re an ambitious teenager or an adult settled into your employment, knowing why people tend to lose money during their investing endeavors and subsequently avoiding these pitfalls may keep you one step ahead of the game.
1. Cash Aside.
According to a 2018 Reuters report, over 20% of retail investors (people who trade from home) admitted to investing without having any other savings kept aside. If you are keen on economic affairs, you’d know that 2018 was not the best year to play recklessly in the markets.
Here, by playing all your money in the markets, you are risking your capital without any essential back up, and therefore open yourself up to a myriad of consequences if the year goes poorly, as 2018 had. In the worst case - and an unfortunately common one - such circumstances result in people having no money left over whatsoever.
If you’re a teenager, this outcome is generally feasible: you have no dependents, which means that you can easily borrow more money from your parents again or simply not invest if you don't enjoy the thrill of it. In fact, the lessons gained from losing your money at a young age are extremely valuable on their own, because they ensure that such mistakes won't be repeated in the future, when the stakes are much higher.
However, consider this example of a middle aged couple who entered the markets without keeping sufficient cash aside:
In November 2018, Trish and Bryan Paling had over £272,000 of their savings put into a Forex trading account, in hopes of further growing their capital before they moved to Portugal for retirement.
In a wave of unexpected consequences, the entirety of their investment was lost due to poor financial advisory as well as inadequate accounting from the financial service company.
Source: (The Sun, 2019)
They were convinced that this was a trustworthy provider they were working with, and had even conducted a fair amount of diligence on the process themselves. While they had the correct approach here, the biggest mistake was playing with the entirety of their savings: no matter who the investment provider is, investing all your savings is clearly a grave mistake.
Whether you're worth $1000 or $1 million, investing all of your disposable income renders you completely cashless in situations of urgency and even prevents potential reward. For example, if Trish and Bryan retained some back up cash, they would’ve been able to:
a) pursue legal action against the provider and potentially have their money returned.
b) still move to Portugal and enjoy an adequate retirement.
c) perhaps even regain their lost profits by reinvesting!
While Option C seems an unlikely stream for people who have just lost hundreds of thousands of pounds, it’s still a viable solution: one that has made fortunes for individuals time after time.
Consider Chris Sacca – billionaire investor in Twitter, Uber, and Instagram – who was $4 million in debt from some poor investments in his thirties. However, because he still retained some cash on the side, he was able to re-invest money after comprehending his mistakes, and regain the $4 millies he initially lost thereafter. This was the first step in building his $1.1 billion fortune today: something that may not have been achieved if he didn’t have the means to dig himself out of financial trouble. In other words, if he didn't have the cash kept aside.
More than ensuring that you do not lose all your money in the stock market, having back-up opens the pathway to make your money back even if you’ve lost it.
2. Lack of Patience.
Investing and growing your money is a function of time: i.e. patience is key. As a Twitter user quite simply put it:
“Calling someone who day trades in the market an investor is like calling someone who repeatedly engages in one-night stands a romantic”
Day trading is wonderful and frequently opens the path for large profits, but it’s still akin to trading your time for money: this isn’t passive income or investing. Instead of this, opening several positions on reliable businesses that you’ve researched, and letting that money grow over time is a far more beneficial process. However, prematurely closing your position just because you haven’t made a big profit in 5 days is something that’s frowned upon in the investing community: and it’s known to prevent profit making in the stock market.
While you seldom need to hold your positions for years like Buffet does, a few weeks or months is the optimal way to avoid short term losses and capitalize on longer term gains. Patience is the key to profits, and it’s those who close their positions after several weeks of stagnant growth that tend to suffer the foregone profits in the markets.
This leads us fairly well to the next reason, as a lack of patience coupled with a soft stomach sometimes cause incredibly painful losses, as depicted below.
3. Susceptibility to changing decisions.
Decision making. I dare say that this is genuinely an art when it comes to investing, because it’s the greatest thief of profits to those who do not stand by their choice and hold their positions even at losses. To articulate the practicality of this, consider the scenario below of Marcus’ recent trade of Oil:
Imagine Marcus, an ambitious young investor, opens a $550 position to BUY Oil (with a leverage of x30, which means that his profit or loss will occur as if he had invested $16,500, (30 x 550)). He opens this trade at a price of $56.70, after a significant dip in Oil’s price. The rationale here is understandable, it’s usually a good time to buy an asset after it drops - buy low, sell high - correct?
Figure 1: Price at which Marcus opens an Oil BUY Position:
Immediately after he opens his position, a small drop occurs that causes Marcus to be in a loss of -$38.40…and panic rises. He’s unsure whether his analysis was correct, he doubts the news he read, and he believes a further drop is imminent after this one. Hence, he closes his position at a loss.
This is a prime example of the sequence of thoughts that occur when us young investors see a drop in the value of our position: we fear losing even more money and close the trade straight away. While this may sometimes be a smart decision that saves us money, it’s can also cost us significant profits.
Figure 2: Oil Price After Marcus Closes His Position
As depicted above, the drop that causes Marcus to withdraw his position was solely half an hour or so of poor performance: something that happens on a daily basis and should generally not be considered a catalyst for fear. To further articulate this, let’s consider how Marcus could have made if his fear didn't cost him.
Figure 3: Foregone Profits Due To Premature Closing Of Position:
As you can see above, the fact that Marcus closed his position early lost him the opportunity to earn $158.24 – a 28.77% profit that he would’ve eventually reached if he stuck by his decision and was not fazed by a small, ephemeral drop in price.
Key Point: Leaving your position open after a drop is certainly much easier said than done, so an effective method of overcoming this is by a) setting a stop loss, which is an amount of loss that will close your position immediately, so you’re not exposed to a further drop in value.
After setting a stop loss, b) set your phone completely aside, so that you’re not tempted to prematurely close your position. If the price chart is open in front of you and you watch each movement, you’ll naturally be incentivized to close your trade as soon as you see a small profit. Moreover, this completely defies the principle of passive income, as you’ll still be trading your time for money if you sit in front of the chart all day.
Thus, ensure that you’ve come to a decision that you stand by, and after following through on that, set an adequate stop loss (i.e. 10% of the invested amount) along with the action of leaving your phone aside. Doing these will allow you to limit your loss whilst simultaneously ensuring that you DO NOT miss the opportunity to win bigger profits.
People lose money and fail to retrieve it because they don’t leave enough cash aside to rectify their mistakes. Everybody, even Warren Buffet, Seth Klarman, and Ray Dalio have experienced losses, but they always had capital kept aside to re-invest and make their money back. If there's no extra cash, how can you re-educate yourself or re-invest, and therefore return your losses?
Investing without patience is not investing. Day trading and shortly closing your positions will force you to endure small losses when you could’ve waited and capitalized on the large gains henceforth. Patience is key, so benefit from passive income by opening solid positions and leaving them that way for several weeks or months: don't fall into the trap of always closing a position because a good investment isn't making profits at the moment
Finally, holding your decisions and sticking by them is perhaps the most important point here. The example in this section directly outlines the opportunity cost to investors who close their positions early. While it’s perhaps correct to do this when there’s a massive plummeting in price, small drops are generally harmless. Yet still, it triggers those who watch charts all day to close. In order to counteract premature closing, set a stop loss function and leave your phone aside: this will almost always translate to much higher gains earned and prevent you from losing money in the markets.