How to Lose Money in Stock Markets !?

Updated: Aug 30

Learn to take losses. The most important thing in making money is not letting your losses get out of hand – Marty Schwartz

*Article is first drafted in Feb 19 and updated again in Aug 20.


Are you trying to be funny?


I am not trying to be funny with the title of this post. The reason for guiding you on how to lose money in the stock market is because you WILL EVENTUALLY experience losses in the stock market . Regardless if you are an investor or a trader, you must be aware that without proper management of the losses, your capital will take a huge hit and this can put an end to your investing or trading career.


Before I continue, I will like to highlight that my background in competitive volleyball (weird flex - I played in the school teams when I was younger) and some of my pastime (Dota & Jutjitsu) had helped with my investment journey.


How did those things help?


First being in competitive games/sports, we know that losing is part of the game. By being able to accept that I screwed up and lost a game, I am able to cut my losses quickly on wrong investment decisions. This protected me from busting my brokerage account.


The idea is that you must accept that you are wrong, take the losses like man, so you can live to fight another day in the financial markets. I believe this kind of mindset of being able to accept losses is not only applicable in investing, but it also works in other areas of life such as in your careers and relationships. 长痛不如短痛... Rather than sustaining pain for a long period knowing your are wrong, why not get out sooner instead of holding on to your ego?

Risk of Ruins


Whenever we invest our money, we must consider the worst case scenario when our investments go against us. Only when we consider our worst case scenario, can we then decide if we are taking on too much risk. Some of you may ask how can we know what is our worst case scenario? I usually use history and of course some logical common sense to determine my worst case scenario.


For instance, when investing in the US stock markets, I look at the historical price declines of the S&P 500 price index as my reference.

Since 1956, the S&P 500 declined an average of 34% in the past 11 bear market (defined by 20% decline of stock market). The S&P500 had the worst price decline of -56% in the 2008 Global Financial Crisis.


Now with this reference, let me ask you a question. If you had invested in the S&P 500 Exchange Traded Fund (ETF) and it declined by 50%, how much percentage must the S&P 500 ETF rise for you to make back your losses?


50%? NO! It's 100%!. Not convinced? Let's do a hypothetical example.


If you had invested US$10,000 in the S&P 500 ETF (Ticker:SPY) at its all time high of US$350. Suddenly, SPY crashed 50% from US$350 to US$175. Your investment is now left with US$5,000.


Then came the announcement of the Federal Reserve Board (FED) announced Quantitative Easing to save the economy and the S&P 500 ETF exploded 50% upwards!


Now the question is: Will the 50% increase bring back all your capital?


NO!


Here's why. If SPY rose 50%, its stock price would have only rose from US$175 to US$262.50. (US$175 X 150% = $262.50)


How much is your investment portfolio now? It's now only US$7,500. You are still down by US$2,500.


So how much % do SPY needs to increase to make back your capital? It's actually 100%.


Now, the point I am trying to make is that the same % decline will require a higher % increase to make back your losses.


Let's take a look at this risk of ruin table below to determine how much % gains is required for each % declines.


If you had lose 10% of your capital, well it’s not that bad, you can recover with a 11% return of your remaining capital.


But as you lose more % of your capital, the required gains on your remaining capital to recover your losses will become increasingly more difficult. If you lost 90% of your capital, you would need 900% returns to make back your losses!


Now there's a difference between investing and trading.


In Investing, we buy a company stock because we believe in the company's long term sustainable growth and we stay invested throughout it's up and down for decades unless your original thesis for investment failed. For example, during the 1999 Dot Com crisis, many internet stocks went belly up. Even Amazon stock went from an all time high of US$113 to a low of US$5.50. That's a 95% decline! That means your investment will now need to make a 2000% return to make back your losses! But thankfully, we know that today's Amazon stock price is US$3,453. That's a 62,700% increase since then and investors would be glad to have held on to Amazon's stock throughout.


Now the thing is not every stock is a 627X wonder like Amazon. And that's the bias that many beginner investors or traders have. They think that whatever they are investing in will be the next Amazon. On hindsight, it seems hugely rewarding to hold a stock throughout its crash BUT what if you invested into other companies like pets.com, eToys.com or Webvan.com? Yes, you probably wouldn't have heard of these companies because they went out of business after the dot com bubble burst and you would have lost a considerable sum of money (many internet stocks lost more than 90%). According to the risk of ruin table, you would need to find an investment that can make 900% to make back all that lost capital. Good luck with that!


That is why many beginner investors or traders bust their brokerage accounts. They fail to realise the importance of capital management. Due to anchoring, confirmation bias, hindsight bias and overconfidence, untrained investors or traders usually believe that their trades will definitely work in their favour, and even if it retraces significantly, they will think that it is just temporary, until it is too late.


Today’s Apple could be yesterday’s Nokia, today’s Google could be yesterday’s Yahoo, today’s JP Morgan could be yesterday’s Lehman Brothers. We cannot predict the future, but we can predict our worst-case scenario using the above knowledge of capital management and prepare for it.



In trading however, we really don't care much about holding a company for a long term. We get in and out based on our trading strategy with a preset entry and exit rules to make money based on a positive expectancy.



If I am a long term investor, how can I protect my portfolio during crashes?


It depends on your strategy. Are you a long term investor or a short term trader?


If you are a long term investor, you are going to want to invest in quality companies that can grow sustainably. Yet, you wouldn't want to put all your eggs in one basket, unless you have a ginormous risk appetite or you have absolute faith that this company can make it. In essence, the higher risk you take, the more rewarding you can get.


For me, I don't have such balls of steel, I prefer to diversify into several companies. What if the company has fraud issues (e.g. Enron, Wirecard, Theranos or Luckin Coffee)? You could have done the best fundamental analysis based on their financial statements, data reports or even be the best friends with their CEO. All you need is one blacksheep to say "Sorry all that is fake" and you can say bye bye to your all-in bet.


So how do you diversify? Simply just buy a few companies instead of 1. Given a hypothetical example below where you invested in 3 companies instead of 1


Company A declines at -20% a year

Company B grows at 0% a year

Company C grows at 20% a year


After 30 years,

Your money in Company A is almost zero

Your money in Company B is the same

Your money in Company C is almost 200 times it's original amount


Even if two companies under-performed, that one company stock will help you erase all the losses in the other two.


And of course, the more you diversify, the less risk you have but you could also decrease your returns as you hold more companies that under-perform.


If I am a short term trader and sometimes I even trade on margin, how can I protect my portfolio during crashes?


If you are a short term trader, and you trade based with leverage, then you better not be holding your stocks and diversify like a long term investor as described earlier.




The easiest way for limiting your losses in the stock market as a trader is to use stop loss orders when entering trades.


What is a stop loss order? A stop loss order is an order placed with a broker to automatically sell a security when it reaches a certain price.


For example, if you are an investor holding one unit of stock (long) at $100 and you want to protect your position against a significant decline, you can set a stop loss sell order at say $90. If the price goes below $90, the stop loss order is triggered and automatically your stock will be sold at the current market price. In this way, you are essentially limiting only your lost to $10 provided that there isn’t a major gap down. (If price drop instantaneously from $100 to say $80, usually from a major bad news, then you will only sell your stock at $80)


For every stock trades in my entire trading journey, I have never failed to diligently place a stop loss to protect my positions. On top of that, I also purchase put options to hedge my risks (Post on Options on another day). This keeps me sane especially with the number of trades I make a week. As I am prepared for the worst-case scenario, even if tomorrow a recession hits, I may feel a pinch, but I will be fine.


As a rule of thumb, don’t lose more than 2% of your capital per trade or investment. Using some intense calculations of probability which I don’t want to bother you with, even if you are only right 50% of the time (i.e. 1 out of 2 stocks go in your direction), with a capital loss per trade of 2%, the maximum draw down if you are super unlucky is 32%. (Referring back to the risk of ruins table, you will need only 45% to make it back - still possible for a comeback)


Below are some ways on how you can set your stop loss and limit your loss to only 2% per trade.


Scenario 1

Trading capital: $1,000

Desired capital loss per trade (1%) = $10

Stock price: $100

Desired no of shares to buy: 1 unit

Stop loss: $100 - $10 = $90

Maximum loss: $10


Scenario 2

Trading capital: $1,000

Desired capital loss per trade (2%) = $20

Stock price: $100

Desired no of shares to buy: 1 unit

Stop loss: $100 - $20 = $80

Maximum loss: $20


Scenario 3

Trading capital: $1,000

Desired capital loss per trade (2%) = $20

Stock price: $100

Desired stop loss identified from a key support level on the charts: $95

No of shares to buy: $20 / ($100 - $95) = 4 units

Maximum loss: $20



Another point to note is that the larger the stop loss distance is from your entry price, you are giving it more breathing room for it to retrace during short term volatility but the rewards can be highly rewarding .So again it's the risk reward concept. The more you give, the more you are rewarded.


In summary, we all have our own way of investing/trading/managing risks. Just take the knowledge shared above with a pinch of salt. What works for me wouldn't work for everyone as I realise that investing is a personal journey and its results is just a reflection of a person's character rather than his/her knowledge.


This article is not to help you make money. But to help you learn how to lose money in the stock market. Because if you can survive a good bear market, you will be ready to ride the next bull market for the next few years to come. All the best!


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Protection is really critical and having a stop loss or diversifying your stock positions are like having multiple insurance plans for your stocks. If you have any questions on calculating position size and risk management, just drop me a message on Facebook. Remember, the day when you stop learning, is the day you stop earning. Keep hustling, fellow Millennials.


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