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How to avoid self-destructive investing
(My intention is not to create panic. This is only for awareness. Keep it in back of mind)

During a stock-market decline, there are those who panic and sell. And then there are those who don’t have any choice.

In late 2008 and early 2009, I remember talking to many investors who lost their nerve as share prices plummeted. Some of those who dumped stocks were folks I considered to be seasoned investors.

But today’s column is aimed at a different group: those who set themselves up for failure before share prices even decline — by pursuing high-risk investment strategies that just don’t make sense for the typical investor.

Flirting with zero

Let’s say you take out a margin loan, which involves borrowing against your portfolio’s value. You then use that money to buy additional shares, so you end up owning, say, twice as much stock as you could otherwise afford.

That leverage should prove mighty rewarding if shares rally from here. But if, instead, stocks tumble, you could get a margin call demanding that you repay part of the loan. At that point, you might be forced to sell shares and give up all chance of recouping your losses. In a sign of the market’s frothiness, margin borrowing has doubled since the start of 2010.

Selling put options can also lead to permanent losses. When you sell a put, you receive a premium from the option’s buyer. In return, you give the buyer the right to sell you shares at a specified price. If the stock falls far below that price, you will lose a fistful of money—and the premium received will be scant compensation.

You could also suffer large, permanent losses if you bet heavily on a few stocks. While it’s reasonable to expect the broad market to rebound from a severe decline, there are plenty of individual stocks that plunge and never recover. Just think about all the dot-com companies that went out of business during the 2000-02 bear market.

In addition, I would be leery of leveraged stock funds. For instance, ProShares Ultra S&P 500, an exchange-traded fund that aims to deliver twice the daily return of the S&P 500-stock index, lost an eye-popping 84.7% from 2007’s market peak to 2009’s trough, according to Chicago investment researcher Morningstar.
Amazingly, the fund eventually recouped that loss, though it’s hard to imagine many shareholders toughed it out through the entire roller-coaster ride.

Keep in mind that such brutal losses aren’t just a bear-market phenomenon. In a rising market, there are other strategies that also offer the prospect of staggering losses. Suppose you borrow shares and then sell them short, in a bet that they’ll fall in value. If, instead, the stock rallies, there’s no limit to your potential loss.

Similarly, in a rising market, you can face hefty losses if you sell so-called naked call options. Buyers of these call options have the right to purchase the underlying stock from you at a specified price. But because you don’t own the stock — hence the term “naked” — you could lose big money if the shares climb sharply.

All this talk of buying on margin and selling options might seem irrelevant, because you have a plain-vanilla diversified stock portfolio. Still, you too could suffer permanent losses during a bear market — if you’re forced to sell stocks to pay for upcoming goals.

Give it five years

As a rule, money you plan to spend in the next five years should be out of stocks and in more conservative investments, like certificates of deposit and short-term bonds. Why this caution? Even with a five-year time horizon, you could lose money with a diversified stock portfolio.

Consider the S&P 500’s SPX, -1.15% performance since year-end 1925, which includes 84 rolling five-calendar-year periods. Morningstar calculates that stocks lost money in 12 of those five-year stretches, or 14% of the time. This performance includes reinvested dividends.

What if you look at 10-year stretches? The S&P 500 lost money in four of the 79 rolling 10-year periods, or 5% of the time.

Let’s say you have money you plan to spend in the years ahead on retirement living expenses, college costs or a house down payment. Once your goal is five years away, you should look to move the money involved out of stocks. If shares are currently in a funk, you might hold off selling and see if the market recovers.

But if stock prices are at or close to their highs — which is where we are today — consider shifting the money into conservative investments, so you avoid the risk of selling shares at fire-sale prices.

Some people set themselves up for failure before share prices even decline, by pursuing high-risk strategies that make no sense for the typical investor — things like margin loans and leveraged funds.

This article is written by Jonathan Clements