When it comes to investing in the stock market, you never want to borrow and invest any money you cannot afford to lose. Always make sure you have 6-12 months’ worth of your monthly expenses in savings before you put a dime in the stock market.
Remember, even though you might be investing in some of the best and most stable stocks around (with the stuff that you learn on this site!), no one can fully predict which way a stock will go in the short term and you don’t want to be caught in a situation where you forced to sell your stocks because you desperately need the money to survive. Ouch!
So how does leverage (borrowing money) make this scenario even worse?
Before we dive into that, let me show you how leverage works.
Let’s say you invested $1,000 in Apple stock and it rose by 25% over the next few months. How much would your profit be? $250. Simple enough.
Now with leverage, let’s say you invested the same $1,000 and also borrowed another $1,000 to invest in Apple stock and it rose by 25% over the next few months. How much would your profit be now? $500.
Instead of making just $250, you doubled your returns simply by investing with the extra money you borrowed.
But leverage can cut both ways…
While you stand to gain more when a stock goes up, you also stand to lose more if it goes that other way.
For example, let’s say you invested the same $1,000 and also borrowed another $1,000 to invest in Apple stock, but this time Apple stock fell by 25%. How much would your losses be? $500.
So instead of losing just $250, you lost half your capital because you borrowed to invest. Now if the stock continues to tank and your losses exceed your entire capital, your stockbroker can issue a margin call, forcing you to deposit more money into the account (to cover the losses).
And if you don’t have the cash to cover that difference? That’s when you start to see scenes from a 90s Hong Kong drama series or movie where you see a once arrogant stock market maverick reduced to bankruptcy, losing his home, family and friends in the process. Yes, very dramatic I know. But something that could happen to anyone if they’re not careful. But if you don’t borrow any money and you only invest what you can afford to lose, you can sleep soundly at night knowing nobody can issue a margin call on you.
So unless you somehow have an improbable, egotistical need to usurp Warren Buffett as the “Greatest Investor of All Time”, there’s really no need to prove to the world how much you can make from the stock market.
Don’t be greedy! Because I’m sure you would agree that no amount of greed and potential profit is worth losing all your savings, your home and providing for your loved ones. Focus on how to preserve your capital and how you can grow it in a safe and steady way – and not how much you can make in the shortest time possible.
Leverage can also affect you emotionally.
If you gamble with money you can’t afford to lose, you start to panic when a stock starts going south. So even though the stock might be a great investment in the long term, because you can’t emotionally (and financially) stomach the short-term volatility, you are forced to cut your losses.
Remember, nobody can accurately predict with 100% certainty which direction a stock will go in the short term. Not even the most brilliant of investors can predict when the next bull run or market crash will happen.
So to end this off, don’t invest money you can’t lose and risk losing everything you have. Invest smartly and safely and you’ll know that, despite any temporary setbacks, you’re still on course to building a lifetime of wealth for you and your loved ones.