A few years ago, a story was making the rounds on various financial web sites about an investor who made a bad trade…..a really, really bad trade. Here’s a link to one such report.
Long story short – and minimizing the technical nature of what happened – an investor predicted that a stock price would go DOWN and “shorted” the stock to make a profit (if it did go down). Basically, he borrows someone’s shares, sells them, hopes the price will drop, and then he’ll repurchase the shares at a lower price and give them back to the original owner.
Easy money, right? Not always, as he found out!
If the price skyrockets, you will incur HUGE losses as you’ll have to repurchase the shares at a higher price to replace the ones you borrowed. That is exactly what happened to this poor soul. An account previously worth $37,000 plummeted to a NEGATIVE $106,455 overnight – a decline of $143,000. Now he has to liquidate his (and his wife’s) 401k to cover the loss. I hope he has a comfortable sofa because he’ll probably be sleeping on it for a while.
Obviously, he didn’t understand the risk he was taking, nor did he take the steps necessary to minimize his potential loss. By his own admission, he was a “fairly new trader” and he (incorrectly) thought his loss couldn’t exceed the balance in the account. He just received a pretty expensive education.
What Can We Learn About Investing From This Sad Situation?
I’m not sharing this story to pick on him; plenty of other people are already doing that. I’m sharing it because of what we can learn from it. This situation is a case study for a few core investment principles:
1. Only invest in what you fully understand
One of the absolute requirements of sound investing is to only invest in what you fully understand. This is non-negotiable. Unfortunately, there are many investment products that are far from being in your best interest. Failure to understand an investment product can lead to unanticipated losses or incurring unnecessary fees and taxes.
☝️ Remember: If it sounds too good to be true, it probably is!
2. Recognize that fear and greed can influence us…and don’t allow them to do so
Sometimes (as it seems to be the case in this example), it’s simply an investor’s greed that will lead them into an “investment” that never should have been made.
Fear can also lead us to make poor investing decisions. Fear can keep us on the sidelines, afraid to invest. It can keep us in an investment we should sell, fearing it will go up eventually and we’ll miss out. Or fear can cause us to make an investment we shouldn’t, again fearing we’ll miss out on an easy gain.
3. Plan your investments in advance
When we don’t have a plan for our investments, it’s easy to get distracted and chase investing “opportunities” that aren’t in our best interest.
This is why I am such a huge advocate of developing an Investment Policy Statement (IPS) to determine where you will (and won’t) invest. I know that my IPS has saved me from potential investment mistakes.
It doesn’t have to be an overly complicated document, just something that will help keep your emotions in check when it’s easy to be greedy (or fearful). For more information on the IPS, please see.
How to Avoid Investing Mistakes
In order to avoid investing mistakes like the one described above, there are some key points you should understand before investing.
- What is the cost of the investment?
- How high are the expenses of purchasing and/or selling the product (ex. Trading commissions and fees)?
- What are the potential tax effects of the investment?
- How large is the potential loss (can you lose more than you invested)?
- What will trigger me to sell the investment?
- How does this investment fit into my overall investment portfolio?
An IPS (as described above) will prevent you from having to answer these questions every time you are ready to invest. You will have already answered them and the only decision still to be made is whether the proposed investment fits within the answers.
If you can’t get comfortable with the investment, my recommendation is to delay purchasing until you do. Yes, you may “miss out” on a profitable investment, but it feels more like gambling rather than investing.
For more tips on successful investing, please see the Top 10 Fundamentals of Investing post.
While it’s too late for the investor in this story to avoid his loss, we may still have the opportunity to correct investing mistakes we have made, or at least minimize the loss.