The stock market can be a daunting place for relatively new investors. One question that often arises is, “can you lose more than you invest in stocks?” Keep reading for the answer – and some tips for managing risk wisely when investing in the stock market.
Can you lose more than you invest in stocks?
The short answer is that you can, indeed, lose more than you invest in stocks. That’s not how stock market investing works by default, though.
You see, there’s only one way to lose more than you invest in stocks. That’s by borrowing money to invest, which is also known as margin investing.
For example, imagine taking $5,000 of your own money and combining it with $15,000 from your brokerage firm to buy stocks. Despite the fact you only invested $5,000 your maximum potential loss would be $20,000. In other words, if your portfolio became worthless, you’d lose your $5,000 plus the bank’s $15,000.
Most people (including myself) don’t invest this way, though. They invest using cash brokerage accounts in which one can only purchase stocks with their own money. If you invest this way, your losses will be capped at whatever amount you personally deposited.
How margin investing works
Next, let’s discuss what the process of investing on margin actually looks like.
Note: I’m not listing these steps because I recommend following them. In fact, the opposite is true – I don’t recommend margin investing to anyone, ever. I’m listing these steps so you understand just how intentional you’d have to be in order to lose more than you invest in stocks.
Step 1: Open a margin account with your brokerage
Because margin investing is risky (more on this shortly), many brokerages don’t allow it. You’ll need to find a brokerage that does, ensure you meet their requirements (which often includes minimum deposit amounts), and apply for a margin account.
Because margin investing entails borrowing money from your brokerage, you’ll typically be subjected to a credit and income check.
Step 2: Add collateral to the margin account
Brokerages offering margin accounts typically require that you keep a certain percentage of your portfolio in cash. This cash will serve as collateral in the event you end up owing more than you invested.
Step 3: Begin investing on margin
You can begin margin investing once your brokerage makes margin funds available to you. The actual process of making your investments is similar to what you’d go through in a cash account at this point; you’d purchase the assets using available funds. The difference is that a portion of your available funds is borrowed money.
Step 4: Maintain your account balance
As I mentioned earlier, brokerages offering margin accounts expect you to keep a certain percentage of your portfolio in cash. As your portfolio’s value fluctuates, you’ll need to make sure your cash position doesn’t dip below the minimum required amount. If it does, your brokerage may liquidate some of your portfolio’s holdings to keep things in check.
A closer look at margin vs. cash investing
While you now know it’s possible to lose more than you invest in stocks, I imagine you’ve still got a few questions. For example, why would anyone bother with margin investing given the risks? To answer this and other questions, let’s compare margin and cash investing.
Pros and cons of margin investing
Pro: Potentially earn greater returns
This is the primary reason people invest on margin.
Think back to my earlier example (combining your $5,000 with the bank’s $15,000 to invest). This time, however, imagine your portfolio’s value rises by 10%. You’d profit $2,000 – not bad considering you only invested $5,000. In fact, that’s a gain of 40% – pretty damn good. At that point, you could liquidate your portfolio, give your brokerage its $15,000 back, and walk away $2,000 richer.
Con: You can lose more than you invest
Of course, stocks don’t always increase in value. Sometimes they decline. If that happens while you’re investing on margin, you’ll be on the hook for however much of your brokerage’s money you lost.
Pro: Unlock the ability to bet against (short) stocks
Margin accounts also allow you to bet against stocks. This is known as shorting. If you think a particular stock’s value will decline, you can do the following in a margin account:
- Borrow shares from your brokerage
- Immediately sell the shares at their current valuation
- Re-purchase the shares at some future date when their value is hopefully lower
- Return the shares to your brokerage, keeping the profits for yourself
Of course, there’s a nasty downside here. If the price of a stock you’re shorting increases, you could theoretically end up owing your brokerage an infinite amount of money.
If they give you 1,000 shares at $50 each and the price per unit rises to $500, for example, you’ll owe them $450 per share ($450,000 total). Yikes.
Con: You can mess yourself up royally
When you read stories about people butchering their finances through risky stock trading, nine times out of ten the critical mistake they made was trading in a margin account.
Robinhood (one of the most popular brokerages offering margin investing accounts) actually had to pay a massive $70 million fine in part because regulators felt its advertising around margin investing was misleading. This came after story upon story of Robinhood investors losing everything (and then some) on the platform.
Bonus con: You’ll need to pay interest
For the sake of simplicity, I’ve left out one aspect of margin investing – interest payments. It’s definitely something you’ll need to think about when investing on margin, though.
Brokerage accounts don’t lend money out for free. Rates can climb into the double digits depending on the brokerage and your credit. This can dramatically increase the returns you need to make margin investing worthwhile.
Pros and cons of cash investing
Pro: Build wealth reliably
While margin investing has become all the rage lately thanks to apps like Robinhood, there’s nothing wrong with an old-fashioned cash brokerage account. If you deposit money consistently and buy good assets with it, you’ll have no problem building wealth over the long haul.
Con: You’ll miss out on leverage
Leverage is what makes margin investing so powerful (and so destructive). Without it, you’ll only generate returns on the money you’ve personally invested. While there’s nothing wrong with that, it’s a much slower path forward.
Pro: There’s less risk
As I mentioned earlier, your maximum potential loss in a cash brokerage account is however much money you personally deposited. In other words, with a cash brokerage account, there’s no scenario in which you’d lose 100% of your portfolio’s value and still owe some other party. The worst-case scenario is ending up back at square one.
Con: Your cash will be tied up
People often use margin investing as a means of keeping their portfolios liquid.
For example, imagine you have $100,000 to invest. Rather than sinking all of it into the stock market, you could invest $80,000 of your own money and invest $20,000 on margin. You could then keep your remaining $20,000 in cash for other opportunities.
This approach of altering your portfolio’s risk profile creatively isn’t possible with a cash investing account. You’ll be tying up 100% of your cash.
4 tips for investing on margin safely
1. Don’t do it
With margin investing, there’s no way to completely eliminate the chance you might end up owing more than you invested. Full stop. Stocks decline in value all the time, especially within shorter timeframes. Even a decline of $1 per share will put you in the red when you’re investing with borrowed money.
2. Purchase reliable assets, not meme stocks
If you’re going to trade on margin, choose assets that aren’t excessively volatile. That means staying away from meme stocks that could wipe your portfolio out within a few hours.
3. Diversify your portfolio
When investing on margin, you might also want to consider diversifying your portfolio’s assets based on type and risk. Check out this article I wrote containing methods for diversifying your portfolio.
4. Be smart about how much you borrow on margin
You don’t have to invest every dollar your brokerage makes available to you on margin. Instead, you might want to consider how much you can comfortably afford to lose and invest within that limit.
Can you lose more than you invest in stocks? Conclusion
To summarize this article, you can indeed lose more than you invest in stocks – but only by trading on margin. The vast majority of retail investors use cash investing accounts. If you do the same, your potential losses will be capped at whatever amount you personally invested.
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