Investing in the stock market comes with inherent risks regardless of what your investment strategy is. Stock prices constantly fluctuate up and down – some days you may lose money, other days you may make life-changing money. While losing everything is unlikely, there is a possibility that you will lose money as you are at the whims of the market. Coupled with leverage, the risk you take on increases significantly.
Depending on how you are investing, you can lose more than you initially put in. Here is everything you need to know before you start investing in the stock market.
- There are two types of accounts you can open with your broker – cash accounts and margin accounts. Cash accounts only allow you to use the capital you have on hand to buy and sell stocks, whereas margin accounts allow you to borrow money from your broker.
- If you use a cash account, you will not owe money on stocks even if they go to zero. However, if you use a margin account, there is a risk that you will owe your broker money.
- While investing comes with inherent risks, there are several steps you can take to protect your finances and build wealth.
Stock Market Basics
When you invest in shares of stock, you are investing in publicly-traded companies, such as Apple, Tesla, or Disney. That means you are a shareholder and own a portion of the common equity in these companies. When these companies do well, you benefit from the share prices going up or dividends that get distributed back to shareholders. For example, when a company’s valuation doubles, your stock value should theoretically double, and when it falls 20%, your stock value will also drop 20%.
Cash Accounts vs. Margin Accounts
For retail investors, you have two options to choose from: cash accounts and margin accounts.
Most beginner investors will start with a cash account, which requires investors to deposit funds in full before purchasing securities. That means you can only use money readily available in your account and cannot borrow money from your broker to buy stocks.
When you buy and sell stocks in a cash account, you need to follow the settlement rules required by the Securities and Exchange Commission (SEC). This process is called T+2 (trade date plus two days), which requires settlement to occur over two business days after the day a transaction takes place.
If you buy stocks, your broker must receive your payment no later than two business days after the sale takes place. If you sell stocks, your shares must get delivered to your broker within two days. For example, if you place a buy order for ten shares of Enphase stock on Monday, it would usually settle on Wednesday. During this settlement period, you do not own the shares even though the transaction appears instantaneous.
Likewise, if you sell any of your positions, you would need to wait for the funds to settle before using the money to make another purchase. If you want to buy and sell stocks multiple times in the same session, you would need to have settled funds in your account to do so.
Pros and Cons of Cash Accounts
If you are relatively new to the stock market, using a cash account has several benefits. The max amount you can lose is whatever amount you put into the markets. While losing your entire investment is possible, you cannot lose more than what you invested or owe your broker money.
Because you can only use settled funds to buy and sell stocks, you have more control over your losses and face fewer risks than a margin account. You also have complete freedom to hold your positions as long as you want. That means you can enjoy the ups and downs of the market without fear of your stocks getting liquidated in the event your account value falls too low.
However, there are a few drawbacks to using a cash account. Because of T+2, any proceeds from a sale get tied up until the transaction settles. Additionally, you cannot sell stocks before the funds to purchase them are settled, or you will risk getting a good faith violation. Multiple violations can result in your account getting restricted.
You also cannot short stocks, meaning you cannot borrow and sell stocks you do not own to make a profit. To short-sell, you need to have a margin account.
Tips to Consider
While cash accounts have limited risk, you should still minimize your investment risk as much as possible:
- Avoid account violations by better understanding the different stock settlement times and types of account violations.
- Do your due diligence before investing. As a rule of thumb, make sure you understand what you are investing in by using fundamental analysis. The fastest way to lose money is to invest in securities you do not understand.
- Only invest and speculate with money you can afford to lose. I only started investing after I built up a sizeable emergency fund. That way I would never have to dip into my retirement accounts or investment portfolios when I need money.
A margin account gives you additional purchasing power by allowing you to borrow funds from your broker using your account as collateral. Think of using margin as taking out a loan or funding debt. You can use margin to add leverage and take on more risk or simply add more liquidity to your account.
Under the Federal Reserve Board’s Regulation T, you can borrow up to 50% of your total account value. If you have $5,000 in your account, your broker will give you an additional $2,500 in buying power to purchase securities. While using margin gives you much greater purchasing power, you get exposed to higher loss potential.
Because you are effectively using your account as collateral, you risk owing money on your stock purchases if prices dip and typically have to pay interest for borrowing money. Over time, this can negatively impact your investment returns.
Additionally, you risk getting a margin call from your broker. To use margin, your account needs to stay above a maintenance margin of at least 25% at all times. In other words, you must have at least 25% equity in any stocks purchased on margin. If your stocks lose value significantly or fall below the maintenance margin, you could be subject to a margin call, which will require you to either add more money to your account or liquidate your stocks.
Pros and Cons of Margin Accounts
Margin accounts come with their fair share of benefits and drawbacks.
You have much greater purchasing power, so you do not need as much cash on hand to purchase stocks. With more buying power, you can amplify your returns and take advantage of price movements in both directions by buying and shorting stocks.
While you can amplify your gains, the same applies to losses. If your stocks lose value, you may have to pay interest on top of your borrowed money. Depending on the interest rates, this can eat a significant portion of your returns.
With any loans, there is an additional layer of risk involved compared to using settled funds. If you get a margin call, your broker may automatically sell your securities or force you to sell them to meet their margin requirements.
Tips to Consider
If you decide to take the risk by trading on margin, make sure to:
- Leave some cash in your account at all times to reduce the likelihood of getting a margin call. Additionally, make sure to have cash on hand for worst-case scenarios, whether that is your emergency fund, checking account, or other assets.
- Pay down your interest regularly to prevent your debt from snowballing. At a minimum, pay off the interest and some of your principal every month.
- Establish conservative buy-and-sell rules to protect your assets. Manage your risks properly to ensure you balance between wealth preservation and growth.
What Happens When the Stock Price Declines?
As an investor, one of my main concerns is the value of my investments. That is why I check my stocks every single day to gauge market sentiment and stay up to date on financial news. When your securities lose value, normally you will not owe money to your broker unless you used margin. However, if you decide to sell your positions, you may not get all your money back if the stock prices have declined since your initial investment.
There are many reasons stock prices will fall. If a company has a major scandal, announces layoffs, fails to meet earnings expectations, or high-profile executives leave, that could cause the prices to fall. When the prices fall, the value of your investment decreases too.
What Happens When the Stock Price Goes to Zero?
If your stocks go to zero in a cash account, you only lose the amount you put in. But, if you are using a margin account, you may lose what you put in and owe your broker money for the balance on your margin loan. If you shorted a stock, you have earned the maximum possible return and may keep all your profits.
Note that when a stock drop to zero, it risks getting delisted by its stock exchange. Typically, this may happen if the company goes bankrupt or gets shorted into oblivion for any number of reasons. In other words, the stock is worthless.
Can Stocks Go Negative?
Stocks cannot go negative. The lowest it can drop to is $0 per share. If the price went negative, that means you would have to pay someone to take your shares from you, which would not make sense since it does not cost you anything to own stock with a negative value.
Can You Lose More Than You Invest?
In short, yes, you can lose more than you invest. But, that depends on the type of account you have and how you are investing your money. If you invest in stocks with a cash account, you will not owe your broker money even if the stocks go to zero. However, if you buy stocks using borrowed money, you will need to repay your debt regardless.
5 Ways to Protect Your Money
While there are risks involved with investing, there are steps you can take to protect your money. Some effective methods include:
- Use stop-loss orders to set a cap on the amount of money you can lose due to unfavorable price action.
- Diversify your investment portfolio. That includes investing in a variety of stocks and types of securities. For example, you can invest in broad market index funds, such as VOO or SPY, and other assets, such as real estate, bonds, commodities, and crypto.
- Invest for the long-term. While some people prefer day trading or scalping, time in the market always beats timing the market. As a buy and hold investor, I have found buying the dips regularly and riding out market downturns highly effective.
- Think through your investment strategy before taking action. Consider your risk tolerance and personal circumstances. How much do you have to invest? How much risk are you willing to take? Carefully weigh your risk to reward ratio to find the right balance for yourself.
- Stay on top of current news. By regularly digesting the news, whether through YouTube, podcasts, news channels, financial publications, etc., you ensure that you have enough information to make wiser decisions.
The Bottom Line
As retail investors, we are often at the whims of the market. One day, we could be looking at 400% gains. The next day, everything can come crashing down (which has unfortunately happened to me). It is not always possible to forecast price action or find the right time to invest.
If you are new to investing, we recommend starting with a cash account to minimize your risks. Once you gain more experience, a margin account may become more beneficial for your investment strategy.