Every investment comes with a certain degree of risk, regardless of the asset type. And as an investor, it is crucial to understand that losses are a part of investing and are bound to occur one way or the other.
Speaking of investment, stocks are the most widely chosen asset class among individual investors. They have secured their top place among all other investments due to their high return potential and ability to diversify the overall portfolio.
However, stocks are also one of the most volatile asset classes with a high risk. This has made potential investors, more so novice investors, remain skeptical about investing in stocks. But can you lose more than what you invest in stocks?
This article will tackle every question and doubt surrounding this topic to help you make an informed decision. Stay tuned!
Can You Lose More Than What You Invest in Stocks?
The answer is yes, you can lose more than what you invest in stocks. However, this will mainly depend on a few items; they type of account you have and the trading you indulge in. Sounds complicated? Here is a breakdown of how you may experience huge losses with stocks.
Typically, investors will use two main accounts when trading stocks; cash accounts and margin accounts. These accounts have different rules when it comes to incurring losses and how they operate.
Cash Account; Everything You Need to Know
As the name suggests, a cash account requires you to deposit money into your trading account before investing. This means you are only restricted to investing money that you physically have and won’t be able to borrow from your broker. Cash accounts also have strict policies on settlement. For instance, it will take two days for the securities you purchase to be available for trading.
Furthermore, if you sell a security, it will take two days for your money to reflect on your account. During this window, you do now reserve any right to ownership over the security you purchase. This means that if the price of the security drops, you won’t experience any losses until your money reflects in your account.
Pros and Cons of Cash Account
This type of account comes with its fair share of benefits and drawbacks. Here are some of the pros;
You Can’t Lose More Than What You Invest
Losses can be painful, especially on a new venture like the stock market. But with a cash account, you are restricted to only investing money that you have in your account, eliminating the possibility of huge losses.
The Stock Settlement Is Quick and Hassle-Free
Like every other business, quick and swift service is essential. With a cash account, you have the availability of funds almost instantly. This means you can invest quickly when there is an opportunity in the market and not wait days for your money to settle.
It’s Ideal for Beginner Investors
Everyone starts from somewhere, and with a cash account, you can rest assured that you won’t be investing more than you can afford (especially when it involves borrowing and re-paying with interest). In addition, a cash account gives you ample time to understand how the stock market works and the best way to approach trading with the cash you have.
Cons of Cash Account
You Are Limited by the Money Available
You might lose on a good opportunity with a cash account due to a lack of funds. This means that when the market is entering a bullish trend, you might be unable to capitalize on the opportunity if your funds are low.
It’s More Expensive
Since you can’t borrow money from your broker at an interest rate, you will use more cash than you would with a margin account. This can be quite expensive, especially if you invest large sums of money.
Cash Proceeds Are Held Until the Settlement of the Trade
You will not be able to withdraw any money you make from a sale until the trade has been settled. This means that for two days, the proceeds of your trade will be held and can’t be used to take advantage of other opportunities in the market.
Margin Account: What You Need to Know
A margin account works differently and enables investors to leverage their money by borrowing from a broker or other financial institution. This account requires a minimum of 50% down payment, and in return, you can access the remaining amount as a loan from your broker or lender.
This means you can buy more stocks with the money in your margin account than you would be able to buy if you only used cash on hand. This is advantageous if you think the stock prices will increase, giving you higher potential gains.
When you open a margin account, your broker will require that you maintain a certain level of equity to be able to borrow more money. This is known as the margin maintenance requirement. If this ratio falls too low, you will receive a margin call, meaning that you must add money to your account or sell off some holdings to maintain the required level of equity.
Benefits of Margin Account
Higher Purchasing Power
The margin account allows investors to buy more shares of an asset than they would be able to with cash holdings alone. This can increase potential profits if your predictions on stock prices are correct and can give you higher returns than if you invested only with cash.
You Can Profit from Declining Shares
The margin account allows you to purchase stock in a company even if its share price is falling. This can be an advantage as you might acquire shares at discounted prices that could increase in value over time.
Disadvantages of Margin Account
You Can Lose More Than You Invested
Since the margin account requires only a 50% down payment, it exposes investors to higher risks because they invest with borrowed money. If the stock prices decline and you cannot close out your position in time, you could lose more than what you initially invested.
Higher Risk of Margin Call
Suppose the market declines, and you are unable to maintain the required level of equity in your account, you will receive a margin call from your broker. This requires you to add cash or liquidate securities to return your account to its minimum equity requirement. Failure to do so will result in the broker closing out your position and incurring losses.
Higher Interest Can Influence Your Returns
The borrowed money in your margin account carries interest which must be paid to the broker or financial institution. This increases your cost of investing and can reduce your profits over time if not well-considered. Additionally, if you make losses, the interest on the borrowed funds will still have to be paid, which means you’ll be losing more than what you invested.
How Can You Minimize the Risk of Losing More Than What You Invest in Stocks?
Losing your investments can be a difficult experience. However, there are a few ways to mitigate the risk of losing more than what you invest in stocks. Some of them include;
1. Research and Analysis of Companies Before Investing
Conducting proper research and analysis of companies before investing is essential. This involves looking at the company’s financial history, economic climate, and other factors that could affect the stock’s performance. With this, you should be able to identify if the company is a good investment and if its stock is overpriced.
2. Diversification of Investments
Diversifying your portfolio is an excellent way to minimize risk when investing in stocks. This means investing in different industries, sectors, and companies. This ensures that if one stock performs poorly, the other stocks in your portfolio can help balance the losses.
3. Setting Stop-Loss Orders
A stop-loss order is an instruction to your broker to automatically sell a stock if it drops below a certain price. This order helps to ensure that you don’t lose more money than what you’ve invested in the stock.
4. Monitoring Investments Regularly
It’s important to keep track of your investments regularly so that you can identify any potential losses. This way, you can act and sell your investments before they take a turn for the worse. Additionally, monitoring your investments will help you identify profitable stocks and adjust your portfolio as needed.
So, can you lose more than what you invest in stocks? The answer is yes, you can. When trading on margin, you borrow money from a broker to purchase additional shares of stock. If the value of your investments goes down, you could be left with more debt than the amount of money you originally put in.
However, while there are risks associated with trading on margin, it can also be beneficial if you make the right trades. Before investing in stocks, it’s essential to understand the potential risks and rewards. You must also have an appropriate risk management strategy in place before you start trading. This means setting up stop-loss orders, monitoring your investments, and researching the companies you invest in.