5 ways to lose all your money in the stock market

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"In this business if you're good, you're right six times out of 10. You're never going to be right nine times out of 10."
-- Peter Lynch 

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How can you lose money in the stock market? Let me count the ways...

Well, I have counted a bunch and have written about them before, but I haven't exhausted all the ways yet. A few months ago, for example, I issued cautions about timing the market, frequent trading, investing on margin, following your emotions, buying penny stocks, and shorting stocks. Here are five more ways to lose all, or much, of your money in the stock market:

No. 1: Following hot stock tips

This is a classic blunder. Your neighbor tells you about a great stock he heard of and is perhaps investing in, himself. You see some pundit on television singing the praises of a certain stock. Maybe you just read a breathless email that appears in your inbox, telling you of a company about to make millions.

Such promising stories are often just that -- stories. Your neighbor may not be the best investor. He may not appreciate that the company with an exciting new product is laden with debt and running on fumes. He may be about to lose a lot of money on the stock he's telling you about. Meanwhile, the pundit on TV may actually have a terrible or mediocre investing track record. (We rarely learn the track records of such folks, after all.) Even if he's a terrific investor, this particular tip may end up being a regrettable one. The best investors make blunders, too. Warren Buffett, for example, has lamented having bought shares of ConocoPhillips (COP) years ago, saying, "Without urging from [my partner] Charlie or anyone else, I bought a large amount of ConocoPhillips stock when oil and gas prices were near their peak. I in no way anticipated the dramatic fall in energy prices that occurred in the last half of the year."

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If you're going to invest by following anyone's moves in the markets, follow the best investors. But better still, do your own research and thinking about any tip you gather.

No. 2: Investing in poor businesses

Another blunder is buying poor businesses. As Warren Buffett has noted, "It is far better to buy a wonderful business at a fair price than a fair business at a wonderful price." Even worse than a fair business is a bad business. It's easy to be attracted to them because they can often seem cheap, but if their stock price is low or has fallen, it can be for a good reason.

What makes a bad business? There are lots of possibilities: Poor management can have an ineffective strategy, or it may be unskilled in executing a good strategy -- and it may not be candid, either. A lack of sustainable competitive advantages, such as a powerful brand or economies of scale, can leave a company vulnerable to strong and able competition. Lots of debt and little cash can leave a company unable to keep doing what it needs to do to survive.

No. 3: Buying overvalued stocks

Even when you have identified a great, strong, and growing company, it might not be smart to invest in it. Why? Well, its stock might be overvalued at the time. Imagine, for example, that Scruffy's Chicken Shack (ticker: BUKBUK) chain is taking the country by storm, opening lots of eateries and raking in cash. Well, you might be eager to buy in, but if its stock has doubled in value over the past year and it's trading at a forward-looking price-to-earnings ratio of, say, 185, then you might want to hold off. You could instead add it to your watch list, and wait and hope for a pullback in price.

Consider, for example, electric car maker Tesla (TSLA), which has recently been trading at a price-to-earnings (P/E) ratio of... well... actually, it doesn't have a P/E ratio, because it doesn't have that "E" (earnings) yet. It has been posting net losses in recent years as it invests heavily in growing its business. If you've been a shareholder over the past five years, you'd have enjoyed average annual gains of about 65%, increasing your original investment's value by more than tenfold. That's great, and it can make others want to buy shares. But remember that even if you think Tesla's future is golden, you can't be sure of that. It does face competition, as lots of other carmakers are coming out with their own environmentally friendly vehicles, and it has been selling more shares of stock to raise more money, thereby diluting the value of existing shares. If things take a turn for the worse with Tesla, even temporarily, its shares can easily fall to less lofty levels.

No. 4: Underdiversifying

Not diversifying, or diversifying insufficiently, is another common mistake. That can happen when you start investing, if you begin with one or two stocks. It's a reasonable start, but if one of your holdings falls hard, so will your entire portfolio. The following table shows what happens if one of your holdings falls by 50% and the others retain their value:

Portfolio Size

Effect on Portfolio of Having 1 Holding Fall by 50%

1 stock

(50%)

2 stocks

(25%)

3 stocks

(17%)

5 stocks

(10%)

10 stocks

(5%)

15 stocks

(3%)

Another way many people under-diversify is when they hold a lot of stock in their employer. They're already depending on their employer for all their current income, by holding a lot of stock, they're depending on that same company for their future income, too. It can be hard to imagine your employer falling on hard times, but it can happen, and you don't want to possibly lose your job and much of your retirement savings at the same time.

You can do quite well investing in the stock market if you just stick with just a broad market index fund such as an S&P 500-focused one. The S&P 500 includes 500 of the biggest companies in America, and together they make up about 80% of the overall market's value. Thus, as Standard & Poor's itself says, "The S&P 500 is widely regarded as the best single gauge of large-cap U.S. equities." It can be smart to add some exposure to international stocks and real estate, too, perhaps via the Vanguard Total World Stock ETF (VT) and the Schwab US REIT ETF (SCHH), respectively.

No. 5: Waiting to get your money back

Finally, another blunder is hanging on to losers while you hope they will rise in value enough to make your original investment amount back. It's a natural thought: You lost money on a given stock and you're annoyed or upset about it and you vow to sell the stock -- once it rises and you can shrink your loss to zero or at least by a meaningful amount. But stop a minute and think about what you're really doing. There are always strong and growing companies that are trading at undervalued stock prices -- and you could invest in them instead of hanging on to the shares of a company that's struggling, a company in which you have little confidence. Even if you lost, say, 60% of your original $3,000 investment and your shares are now only worth $1,200, you could move that $1,200 into a company in which you have great confidence -- one that seems undervalued and therefore likely to increase in value over time. You might have lost $1,800 on the original stock, but you're more likely to make that $1,800 back (and probably more) if you're invested in a healthy and growing company instead of a struggling one.

Those are just some of many mistakes to avoid if you want to make money in the stock market. Stock investing isn't rocket science and if you're patient and keep learning, you're likely to do well, building significant wealth over time.

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Selena Maranjian has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Tesla. The Motley Fool has a disclosure policy.

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