By investing in the stock market, making money isn’t the only possible outcome for you. Of course, you can also lose your money in various ways. The moment you start investing, you sign up for a ride that can include both. But how can you end up owing money on stocks?
Investing in the market has helped countless investors grow their wealth over time. It has been the greatest wealth-creation machine of our time and before.
But that doesn’t automatically transfer into wealth creation for you. If you don’t know the rules you are playing by, there are many ways you can be surprised.
In your investment journey, you will inevitably make mistakes – I’ve made my fair share of mistakes, too! You can think about them as part of the learning process. It all depends on what you learn from them. What you do next matters most. Do you repeat them, or do you adjust and get better?
In this article, I will explore ways you can lose money on stocks. They can help you navigate the investing landscape and avoid falling for them. But before we dive into that, let me cover some basics.
The Difference Between Paper- and Realized Gains & Losses
So you invested some money in a stock. Your position has grown over time, and it feels great, right?
The first fact that I’d like to discuss is the difference between paper gains and realized gains (or losses). Your grown position, because you still own it, is carrying a paper gain. The reason is simple: It’s only on paper. Tomorrow, the market could evaporate your gain on a single day.
Now, if you really decide to sell the stock position, your paper gain becomes a realized gain. You now officially turned that gain into actual money.
The same is, of course, also valid for losses. They are only realized the moment you sell your stock for a loss.
Can You Owe Money By Just Buying Stocks?
If you buy individual stocks with money you have using a Cash Account, you will never owe money. The most you can lose is your invested amount because stocks can not go below $0.
The company is effectively bankrupt or insolvent if a stock goes to $0. The stock has no value anymore to any shareholder.
The First Way You Can Owe Money On Stocks: Margin Trading
Brokerage accounts can be of different types. The main account types are Margin and Cash Accounts.
With a Cash Account, you can only invest with money that is readily available in said account. So you must deposit money, wait for the amount to settle, and then invest. Another option is to sell an existing stock to have more money available to reinvest.
A Margin Account allows you to invest money you borrow against the value of the stocks you buy (also called a margin loan). You then pay back the borrowed money with interest. Borrowing money can give you more leverage and possibly more profit.
And this is exactly how you can owe money on stocks. If you borrow money and you don’t pay it back in time, interest can start to build up in your account. These interest rates can be quite high.
Imagine you borrow $5,000 to buy a stock of company A for $5 per share. You will own 1,000 shares. The next day, the price of that stock falls to $2 per share. Your position is now only worth $2,000 if you realize your loss. But you still have to pay back your initial $5,000, or it will start to build up interest.
Your broker can demand you put additional money into your brokerage account or sell stocks. This is called a margin call. It can happen when your stock declines and thus has dramatically fallen in value.
Your margin account has essentially run low on funds.
How You Can Owe Money On Stocks Using Short Selling
Margin accounts also allow you to take a short position. Think about it as selling something you don’t own to then buy it back for a lower price. It is a strategy most often used by hedge funds and institutional investors.
With a short position, you bet that the price of a stock is going to fall in a given timeframe. You borrow shares from your broker or another investor. Your risk is that you will have to return those borrowed shares at some point in the future by buying them back.
Of course, you may owe more money than you initially received in the short sale. We have all seen that in the Gamestop frenzy from 2021.
How You Can Owe Money On Stocks When Trading Frequently
Another aspect that is often overlooked is frequent trading. If you find yourself selling and buying stocks frequently, you are essentially realizing your gains and losses frequently, too.
Every realized gain you produce will cause a taxable event for you. Your gain is subject to short-term capital gains if you held the stock for less than one year or long-term capital gains if you held it for longer.
Imagine company stock A having a pretty flat year. The stock didn’t really grow at all. But during that year, it was still a wild ride up and down.
You did everything perfectly and bought $1,000 worth of stock when it was low and sold it when it was high at $1,500. To be precise, you did that twice in the year. At the end of the year, you still hold onto the stock.
Your latest gain hasn’t been realized yet, but from the previous trades, you raked up a taxable short-term capital gain of $1,000. You must report that gain on your tax return.
Short-term capital gains taxes have the same rate as your ordinary income tax rates. They are higher than long-term capital gains tax rates.
Imagine the stock falling deeply, and you still hold onto your position. You will still be on the hook for the capital gain you could offset by selling at a loss now.
As you can see, frequent trading can create a situation where you owe money on stocks. Over time, you can increase your taxable income considerably. You could even jump into a higher tax bracket because of these realized gains.
How Fees And Commissions Can Make You Owe Money On Stocks
Commissions aren’t a big issue anymore nowadays. But some services, like full-service brokers, are still collecting commissions. They are based on the transactions they execute on your behalf.
You are basically paying a premium for research and investment advice.
An area that has gained increasing popularity with the rise of AI is AI trade bots. These bots promise to partially or fully automate trading and increase your wealth using AI-based algorithms. These services, of course, come with various fees and carry a risk, too.
Anytime these services do not yield real returns, these fees will still make you owe money. There is no guarantee of any future returns based on past performance with any kind of investment.
I always say investing can be simple, or it can be as complex as you’d like to make it.
If you ask me, I’d always lean towards a lean and simple approach involving long-term investing. Especially for new and inexperienced investors. And I will give you a few reasons why I think that way:
Cash Accounts involve much less risk.
You want an investment strategy that makes you feel good instead of having to worry about losing money every day.
It is incredibly hard to understand and act on short-term trends.
Long-term investing is a very tax-efficient way to grow your wealth.
Index Funds, Mutual Funds, or ETF-based long-term strategies provide a hands-off approach to investing.
At the end of the day, investing is a 99% mindset game. Making as much money as possible in as little time as possible is a motivation that can cause you to take unnecessary risks.
On the other hand, long-term investing often goes against our internal instincts. It can be boring at times if executed correctly. But that is something I learned to accept as a good thing to embrace as a long-term investor.
Final Thoughts – How Can You End Up Owing Money On Stocks
Your activity can cause you to owe money on stocks in many ways. You can avoid those mistakes by adjusting your mindset and choosing less risky approaches.
Especially if you are new to investing, avoiding these more advanced investment strategies is a good rule of thumb.
More experienced investors can, of course, use them to their advantage. But you should know about the risks before using them.
In this blog post, you have learned about the difference between paper and realized gains and losses. You now also know how using a margin account can cause financial harm if you are not using it the right way.
Excessive trading can cause your tax bill to rise quickly because of the higher tax rate on your short-term gains.
Using the right type of account that aligns with your investment strategy and financial goals is a great way to set yourself up for success for years to come.
Disclaimer: The information in this blog post should not be considered investment, tax advice, or a replacement thereof. They are solely provided for informational purposes. Please consult with a tax professional or financial advisor for any specific questions on your personal situation.