Understand What Defines a LossThere are two types of stock market losses. One is a loss that’s reflected in your net worth, while the other is an official loss. Let me explain this first because before you can address how to avoid losing money in the stock market, you need to know what kind of loss you are committed to avoiding.
A Decline in Net WorthThe first and most common kind of stock market loss is called an unrealized loss in financial and tax lingo. Let’s say you invest $100,000 in an S&P 500 stock index fund, for example. Assume the next month the stock market enters a bear market and drops 50% over the next 18 months. You do not sell your stocks because you know stocks go up and down. This is not what I call an unofficial loss. It is a temporary decline in value rather than a loss. Based on history and math, my favorite investing tools, the S&P 500 index fund will increase in value back to more than you paid for it eventually in this example. This all sounds great, right? Maybe not. Here is an important insight that will affect your wealth. Note that if you update your net worth statement after that 50% decline in value, your net worth will have dropped to reflect the current value of your stocks at any given time. Read my related post How Much of My Net Worth Should Be in Cash?
An Official LossIn tax and financial lingo, an official loss is called a realized loss. Using the example above, if you sold the S&P 500 index fund after it dropped 50%, you would have a realized loss. So, the first step to avoiding losing money in stocks is to define the kind of loss you want to avoid. Read my related post 10 Ways to Reduce Investment Risk While Building Wealth.
Be RealisticIf you’re invested in stocks, your stocks will rise and fall in value every single day unless you’re invested in a rare stock that has no trading volume. This naturally leads to unrealized and often minimal temporary losses. But sometimes the stock market as a whole will drop for more than a year and by over 50% based on history. Fortunately, over time the stock market as a whole increases in value more than it decreases in value. This fact is the lure that attracts investors in an attempt to build wealth passively over time. Here’s the thing. It’s up to every investor to decide:
- How much realized loss they are willing to have
- How much unrealized loss, or temporary decline in value, they will have
Time FrameThe time frame you invest will determine if you make money in stocks or lose money in stocks. It’s that simple. If you buy stocks and hold them over more than 13 to 15 years, the probability is high that you will make money. If you buy stocks when they are extremely overvalued and you sell them five years later, the probability is higher than you will have stock market losses. Keep reading to understand this better. Read my related post Are Stocks Safe for Retirement? and What Will Stocks Do Over the Next 10 Years?
Be Aware of Stock Market CyclesOne of the best ways to avoid losing money in stocks is by understanding stock market cycles. The stock market moves in cycles called bull markets, which rise, and bear markets, which fall. These cycles are usually, but not always, related to what the economy is doing. This makes perfect sense, even though the timing on this is not exact. It makes sense because stock markets generally rise when the companies that offer stocks make more money since investors are happy to pay for higher earnings. And when those earnings fall, investors sell their stocks. Sometimes earnings slow before bear markets and sometimes they slow after bear markets and sometimes the timing is very close. Read my related post What Goes Up When Stocks Go Down?
Use Historical DataWhen you invest in stocks, you can easily look to see where the stock market cycle is relative to history. It makes sense to do this before you buy stocks, and while you own stocks. Here’s what’s tricky. If the stock market has been going up for a very long time, it is closer to falling because the stock market will only become so overextended before It corrects or enters a bear market. On the other hand, if the stock market has fallen significantly, it is more likely that stocks will rise. Read my related post How to Know If Stocks Will Go Up.
Buy What Everyone HatesHere’s the thing. After stocks have fallen by 50%, everyone hates stocks. This can be a great time to buy quality stocks. You’re naturally less likely to lose money in stocks because you have paid less for them. Anytime we pay less for something, we reduce our risk. On the other hand, after stocks have risen for 10 years, everyone loves stocks. This could be the time to take some profits, depending on the amount and type of risk you have decided you want to have, as covered earlier. The challenge is to not follow the herd. This is hard since, as humans, we have a primal instinct to stay with the herd. It’s leftover from our cave-dwelling days. Plus, we are taught as children not to act differently. It’s not culturally acceptable, and it’s certainly not safe. For this reason, most investors are driven to buy stocks near highs and sell stocks near lows. Defining how much risk you want to have and holding firm to that decision from a place of confidence will help you avoid losing money in stocks due to an overwhelming herd mentality. Read my related post How Will a Stock Market Crash Affect Me?
Stock Market ValuationsIf you buy stocks that have unusually high valuations, especially after the stock market has been rising for years, there is a higher probability you’ll lose money in stocks. It just doesn’t feel that way. This is where facts and logic have to guide investing instead of emotions. Note that less exciting stocks with lower valuations and somewhat stodgy dividend stocks tend to drop less during market corrections, thereby minimizing stock market risks. You won’t hear about these stalwarts at a cocktail party. Read my related post How to Manage Risk in the Stock Market.
Stock PickingMany investors think that because they are invested in “conservative stocks” they won’t lose money when the stock market tanks. But almost all stocks go down during bear markets. Dividend stocks just drop less than overvalued stocks that don’t pay dividends yet since investors want to continue to own them to collect the dividends. Read my related post Is Dividend Investing Worth It?
Tactical Vs Strategic Investment StrategiesAn increasingly popular way to reduce losing money in stocks is to use a tactical investment strategy as opposed to a strategic investment strategy which most investors and financial advisors use. A tactical investment strategy considers economic and market conditions in making investments. On the other hand, a strategic investment strategy invests a set percentage into stocks and bonds based on the investors age and desired risk profile regardless of asset valuations. Then the allocation is adjusted annually to return to the original percentages. A tactical investment strategy may, for example, sell an investor’s stock holdings partially or completely as they become overvalued. Later, this same tactical strategy may signal the investor to buy stocks again once they are undervalued. There are many factors which can drive a tactical investment strategy, including both fundamental and technical factors.
Advanced Strategies to Avoid Losing Money in StocksMany proactive investors, financial advisors and wealth managers use advanced strategies to protect their stock investments. These hedging strategies can be complex and difficult to implement, but they can be an effective way to avoid losing money in stocks.
Inverse Stock ETFsInverse stock market ETF’s move in the opposite direction of stocks. In other words, when the stock market is falling, inverse ETF’s are rising.
Protective PutsAnother strategy common among financial professionals and proactive investors is to use what is appropriately called a protective put. Here is how a protective put works. A put is a type of option. A put option gives the owner of the put the right to sell a stock to the option buyer at a defined price, called the strike price. Additionally, the stock has to be bought on a certain date, called the option expiration date. Here’s the thing: put options move in the opposite direction of the stock market. When stocks go down, most stock market puts go up. Some puts represent the overall stock market, such as the S&P 500 index. Other puts represent individual stocks. So, inverse stock ETF’s and protective puts are two common ways to avoid losing money in stocks when they are falling. Since stock market cycles are tricky to time just right, this is something most investors would want to use a financial professional to implement. Many investment funds use these strategies. Normally, I write about investing strategies I have used. While I have used both puts and inverse ETF’s in the past, this is not something that I frequently do as an investor. Instead, I prefer to avoid overvalued investments and to be more of a tactical investor. Sometimes this costs me, but I have chosen the type and amount of risk I want at this point in my life and am good with this decision. Note that even the best investors are challenged to consistently create a perfectly hedged portfolio. Read my related post Investment Strategies a High Net Worth Advisor Uses to Lower Risk for more on this.
Summary for Avoiding Stock Market LossesAgain, the only way to avoid stock market losses is to not invest in stocks or to have a perfectly hedged stock portfolio, which is rare if not impossible. By defining acceptable stock market risk and investing with an awareness of market cycles and valuations, investors can at least mitigate stock market losses, if not invest profitably in the stock market.
The information on this website is for education only and is not to be construed as personal financial advice.