When stock market investing goes bad

In this article we shall talk about different things that can knock you and your portfolio off course, as well as how to get back on track. These pitfalls include trying to “time” the market and buying on margin. Here, we also discuss dollar-cost averaging and the buy-and-hold strategy.

Timing the market

The concept of market timing is very seductive. After all, who wouldn’t want to be in the market during the good times and out of the market during the down times? Market timing is just like a crapshoot. Sure, you may get lucky and wind up gaining more than you anticipated. Or, perhaps, you happened to buy into a stock just before it skyrocketed. But how often does that happen? More importantly, what happens when you don’t time the market well? The key to successful investing isn’t timing the market; it’s time in the market. Investing and staying invested is a long-term way to build your future. Even when the market is down, or going through some turbulent times, it’s better to stay invested than to sell and try to buy later.

Especially when faced with short-term market corrections, getting out of the market may prove to be more devastating than sticking it out. During a bear market, people will call and ask their advisors’ opinion about when they think the market will start to come back. Unfortunately, the fact remains that no one is able to predict what the market is going to do. This leads many people to try and time the market. Brokers get calls from clients asking them to sell all their equities and put them into a cash position. They say that they will then reinvest when the market starts to come back. What they don’t realise is that by the time they think the market is “on its way back up,” they have already missed out on 10-20 percent in growth. By selling during a down market, you turn paper losses into actual losses.

Recently I heard of an instance when the market started to go down dramatically in the 1980s and an investor called his broker requesting that his entire portfolio be liquidated. The market had continued to slide and that he was losing money. He was also concerned because he was taking monthly income out of his investments, which impacted the account values, as well. His overall portfolio was valued at more than one million dollars when we had this conversation. Although he didn’t come out and say it, he was scared about losing his money, and wanted to protect himself against further losses. He wanted the broker to sell everything and put it into a cash account. At that time, time deposits were offering interest rates of about six percent. The client’s financial advisor talked with him, trying to reassure him and convince him that liquidating the entire position was a very unwise idea.

Even with all the reasons he presented to him, he was still very upset and firm that he wanted everything in a cash account. One thing that helped the advisor convince him not to cash everything in was his wife. Although she was terrified, as he was, that they were going to lose their money, she knew that by selling everything they would turn their paper losses into actual losses. Together, she and the advisor convinced her husband not to liquidate everything. They agreed to move a portion of the money into a money market account, and that he would draw his monthly income from there, rather than from another account. Even though this wasn’t what he truly felt he wanted, he was comfortable with this. And the advisor was glad that he agreed not to sell everything.

The advisor was able to talk him down from moving all his money to moving about ten percent. Later, as the market continued to decline, he and his wife reviewed their portfolio with their advisor. They discussed being invested in the market verses keeping the money in a money market account. When they initially moved the money, the money market account was earning about six percent; when they met for their appointment, it was closer to 3.25 percent. Since the investor was taking out nearly seven percent annually, the advisor knew they had to change something. At that rate the investor was guaranteed to lose almost four percent per year. They discussed moving his money back into the market. At first, he was a little resistant, but he knew that he had better reinvest, rather than try to time the market. By holding out until he felt the market was coming back, he was really doing himself a disservice because he was putting himself in the position of missing out on potential growth. During that meeting it was agreed to reinvest his money in the stock market. I know that it sounds like that really isn’t the case; but by taking his money out and then reinvesting it he was doing better. When it comes to timing the market, history has proven that it doesn’t work.

Should I get out of the market?

Period of Investment
Average Annual
Total Return
Fully invested 18.33%
Missed the 10 best days 9.24%
Missed the 20 best days 2.98%
Missed the 30 best days 2.07%
Missed the 40 best days 6.38%
Missed the 60 best days 13.07%

This is based upon a US example of the S&P 500 (stock) returns from January 1, 1996-December 31, 2000. By jumping in and out of the market, an investor dramatically reduces the returns over time. Note that by just missing the ten best days, the total return is reduced by nearly 50 percent. Missing the 60 percent best days would have reduced the overall return 200 percent.

(Refer to the table above) Investors willing to stick out the short-term declines have been rewarded with large gains over the long run. In fact, missing just a few days, even during booming markets, can drastically impact the return on your portfolio. Unfortunately, this type of get-rich-quick form of investing has sucked in many investors. Because of their actions, there have been some volatile days on the market, as prices go up and down.

Buying on margin

As a rule, you should not buy securities on credit. The reason is that it’s just too risky; especially with the way the stock market by its very nature behaves.  When the market is gaining, buying on credit can be great. However, when the market starts to head south, buying on margin can kill you financially. This is how margining or buying on credit works. Let’s say you have $200,000 that you want to invest. You would like to invest more money than that, but you only have the $200,000 available right now. You open an account with a brokerage firm, who then approves you a line of credit or margin. Some brokerage house may lend you up to 50 percent of the total purchase price for stocks. So, let’s assume that you would like to purchase a total of $300,000 of XYZ common stock. You invest your $200,000 and you purchase the remaining $100,000 on margin. The maximum margin amount for this example would be $200,000, making the total investment amount $400,000. You now owe the brokerage house $100,000.

They can, and will, charge you some form of interest on that balance. Make sure that if you do trade on margin, you know what kind of interest rates and payments are applicable. After the initial purchase, you own $300,000 worth of XYZ stock. Now, assuming the market goes up, your share increases, not the part you bought on margin. If the price doubles, your shares would be worth $600,000. Of that $600,000, your portion is worth $500,000. You still owe the house $100,000. At this point, you could sell $100,000 worth of stock, plus whatever amount was needed to satisfy the interest owed on the loan, and pay back your loan to the brokerage house to clear up your debt. Then, your portion would continue to go up and down with the market.

• Your share = $200,000
• Margin purchase
(loan) = $100,000
• Total investment = $300,000
• Market price doubles;
account value = $600,000
• Your share = $500,000

Sounds great, right? Now let’s assume that the share goes down instead of up. Rather than your investment doubling in price, it’s now worth only 40 percent of what you paid, or $120,000. How much is your share worth now? A tidy $20,000. You still owe the house the whole $100,000. And if the price of the stock drops much more, the brokerage house will give you a call and ask you for its money. If the price drops substantially, they will sell off your position to satisfy as much of the loan as possible.

• Your share = $200,000
• Margin purchase
(loan) = $100,000
• Total investment = $300,000 
• Market drops by 60%;
investment worth = $120,000
• Your share = $  20,000
• Loan balance = $100,000

This is the risk of investing on margin or by using credit. Brokerage houses may have the right to sell your securities when asking for their money back because the market price for the security has dropped. If you have the cash to satisfy these margin calls and can pay off your debt with interest to the brokerage house, then you are in the clear. However, if you don’t, then you have to look at liquidating some of your other assets to cover the payment. Investing by using credit  is great when the market goes up. You purchase more securities with the money you borrow from the brokerage house, your investment goes up faster because you own more shares, the brokerage firm is making money off of you in the form of interest, and everyone is happy. However, it’s not so great when the market goes down. Unfortunately, no one knows what the market is going to do, which poses another risk to investing on margin.