The stock market is the greatest wealth creator on the planet. And for that reason, it draws in people from all walks of life, many with little understanding as to how it functions. I’ve worked in the stock market for a decade. My niche is in the small cap space, which consists of early stage companies (very exciting but very risky investments); and in that time I’ve both made and lost small fortunes. Fortunately, I’ve made more than lost and lived to tell about my experiences 🙂 Throughout my years working in the stock market, however, I’ve witnessed some horror stories - people who never recovered from some of their illogical bets (and yes, investing is like betting – albeit more calculated gambles than a casino).

If you’re looking to enter the market with your risk capital (money outside of your retirement), before you jump in I want to share with you the five most common ways I’ve seen people lose money investing in stocks.

Five Common Reasons People Lose Money Investing in Stocks

Invested more than they could afford to lose

I’ve seen people do some crazy things in the stock market, particularly in bull markets. Greed is a powerful emotion…

I know a gent who once refinanced his condo to invest an exorbitant amount of money in a penny stock. Thankfully, he ended up making about 5% on the investment, but it came at a heavy cost…

He was stressed to the max every day as the stock, which like all penny stocks, was extremely volatile. He literally lost sleep over this investment/gamble. Once he hit his breaking point and could no longer handle the stress from all the risk, he sold. Couple months after selling for a measly 5% (not including commission), the penny stock took off on the back of the company inking a major deal. He left nearly 100k on the table as the stock increased 90% from his purchase price. Literally, had he simply invested $10,000, as oppose to refinancing his home and dropping roughly 100k, and rode it out, he would have made the same amount of money without all the stress.

When you invest what you can afford to lose you make better investment decisions. Investing more than you can afford to lose evokes fear and emotional decision making – two things that don’t work well in the stock market.

Trading, not investing

Warren Buffett and Jim Rogers, two of America’s top billionaire investors over the last 50 years, both admit they are terrible at trading and timing market events, so what makes you think you can? Near 90% of traders lose money. It’s a tough game, and requires a full-time commitment. Nay, it requires about 80 hours a week and an exquisitely detailed understanding of how markets behave and the global economy functions. Finding an undervalued company is hard enough, don’t try and time short-term market moves in order to make a quick buck, no matter how tempting it may be. Buy and hold has worked for centuries. Stick to that strategy.

Quora reported that:

40% of day traders quit within a month
87% of traders quit within 3 years
93% of traders quit within 5 years

Why is the turnover rate so astronomically high? It’s very hard to make money trading! Don’t bother.

Unrealistic time horizon

Paul Samuelson, economist and Nobel Prize recipient, famously said “Investing should be more like watching paint dry or watching grass grow. If you want excitement, take $800 and go to Las Vegas.”

Successful investors are very patient. If you’re looking to invest in stocks for a quick buck, think again. Going into an investment with an unrealistic time horizon will set you up for failure, or entice you to give up on a stock far too early and create unnecessary stress. For example, investing in a stock like Microsoft with ambitions of making 20% in the calendar year is an insanely unrealistic goal and time horizon. Statistically, you’ll miss your target by more than 60% (in a good year), setting yourself up for disappointment and a premature sale. Investing in a blue-chip stock with anything less than an 18-month time horizon is rare.

Bought on a ‘stock tip’

News flash! If your neighbor is telling you about a hot penny stock that’s “about to breakout,” it’s too late. Stock tips are just ideas. In other words, stock tips aren’t worth shit. And unless it’s coming from Warren Buffett, stock tips are dime a dozen. Can’t tell you how many times I’ve heard about someone losing money on a stock tip. From my experience, this is the number one way people lose money investing in penny stocks. DYODD! (do your own due diligence)

Bought pumped up stock

Certain stocks, the household names and penny stocks in particular, tend to get overhyped and overbought, removing much of the upside and the attractive risk/reward proposition. Don’t buy a stock just because the media is singing its praises or newsletters are continually touting it. If you’re considering buying a heavily marketed stock, make sure you run a comparable analysis on it at the very least. That way you’ll have a general idea if it is relatively undervalued, or over-inflated. For S&P 500 stocks, at the very least do a comparable study of industry peers’ price to earnings, sales and cash flow ratios, dividend discount, and debt to revenue. You wouldn’t buy a house without finding out what neighborhood comparables recently sold for. Same goes for stocks. Once again, DYODD!

These are just basic comparable tests. I’ll follow up on this subject in another blog to explain how to thoroughly DYODD.

Losses in the stock market are unavoidable. They happen. But they don’t have to be a common occurrence if you know what to look out for. These are the five most common reasons people lose money investing in stocks. And each one is entirely avoidable.

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Stay hungry,

Aaron