Investing always comes with some level of risk, no matter how you choose to invest. Unlike a savings account, where your money is backed by federal deposit insurance, the value of stocks is left up to the whims of the market. And although you may build wealth investing in stocks, it’s possible to never earn any money, and you may lose money, too.
But can you lose more money than you invest in stocks? The answer depends on a couple of factors.
Here’s a look at whether you can actually lose more than you invest in the stock market.
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Can you lose more than you invest in stocks?
The short answer is yes, you can lose more than you invest in stocks. However, it depends on the type of account you have and the trading you do.
Although you cannot lose more than you invest with a cash account, you can potentially lose more than you invest with a margin account. With a margin account, you’re essentially borrowing money from the broker and incurring interest on the loan. If the stock you purchase declines in value, not only do you lose money because of the declining share price but you also have to repay the borrowed money plus interest.
To determine which type of brokerage account is right for you as a beginner investor, it’s best to take some time to familiarize yourself with the two.
Cash accounts: what they are and how they work
A cash account is a type of brokerage account that requires you to pay the entire amount of a security using cash or settled proceeds from the sale of other securities. With a cash account, investing on margin is prohibited. In other words, you can’t borrow money from the broker to purchase a security.
Trades in a cash account have to abide by settlement rules. It takes two business days after the sale or purchase of stock for the transaction to settle. During that time, you don’t officially own the stock. The settlement cycle marks the official transfer of cash to the seller’s account in exchange for the security you purchased. At that time, payment is required in full using cash or the sales proceeds of securities you officially owned.
Investors who use cash accounts cannot lose more than they invest in stocks, though they can lose their entire investment. The price of a stock can fall to zero, but you would never lose more than you invested. Although losing your entire investment is painful, your obligation ends there. You will not owe money if a stock declines in value. For these reasons, cash accounts are likely your best bet as a beginner investor.
Cash accounts: the pros and cons
Someone who’s just getting started in the stock market will likely find several benefits in choosing a cash account. However, it also comes with certain drawbacks.
Advantages of a cash account
- You can’t lose more than you invest. Stocks purchased with a cash account are purchased outright using settled funds. Not only does this save you from spending beyond a limit, but you also can’t lose more than you invest in the stock.
- It poses less risk than a margin account. Because you can’t lose more than you invest, cash accounts carry less risk than trading on margin. This gives you more control over your losses, even when stock prices fall.
- You have the freedom to hold stocks as long as you want. If you purchase stock using cash, you can hold onto it as long as you want. You can ride the ups and downs without fear of being forced to sell your positions if your account value drops too low, which is a risk you take with a margin account.
Disadvantages of a cash account
- Cash proceeds from a sale are tied up until the trade settles. For most stock trades, settlement occurs two business days after the order executes. This is known as “T+2,” or “trade date plus two days.” Only after the trade settles will you be able to withdraw the proceeds from your account.
- There is no short-selling option: Short selling is the sale of stock you don’t own, and it’s a strategy frequently used by investors who believe the stock’s price is going to decline. The investor borrows stock from the broker and sells the stock on the market. If the price drops, the investor buys back the stock at the lower price, returns the borrowed shares, and makes a profit on the difference. Investors must have a margin account in order to short a stock.
- You need to consider settlement periods when you’re making trades. Although unsettled funds can be used to purchase stock, selling the newly purchased stock before the funds have settled will result in a good faith violation. After several good faith violations, you may be restricted to trading only with settled funds.
3 tips for minimizing risk with a cash account
Cash accounts are generally less risky than margin accounts, but they are not immune to risk. Here are some tips for minimizing your investment risk with a cash account:
- Avoid account violations. Understanding stock settlement times and making sure you have settled cash in your account to pay for purchases will help you avoid account violations.
- Understand your investments. Whether you’re investing in an individual stock or a mutual fund, it’s important to understand your investments and how they work.
- Only speculate with money you can afford to lose. Know the difference between investing and speculating. In short, investing involves relatively stable assets, whereas speculating involves taking on more risk for a potentially greater return. It’s possible to lose all the money you invest in stocks, regardless of how stable the asset is. If you’re speculating, only use money you can afford to lose.
Margin accounts: what they are and how they work
A margin account is another type of brokerage account that allows you to borrow money to purchase securities, using your account as collateral. Under the Federal Reserve Board’s Regulation T, you can borrow up to 50% of the purchase price of the stock using a margin account. This can give you much more purchasing power than you’d get with a cash account, but it also exposes you to the potential for greater losses. Your broker will also charge you interest for borrowing money, which will affect the total return on your investment.
For example, let’s say you purchase a stock on margin for $100 and it increases to $150. You paid $50 and borrowed $50 from the broker. Because of the $50 increase in the stock’s price, you earn a 100% return on the money you invested (the $50 gain is 100% of your initial investment of $50).
A declining stock, on the other hand, can quickly result in substantial losses. For example, let’s say that the same stock you bought for $100 falls to $50. After paying back your broker the $50 you owe them, your proceeds are zero. That’s a 100% loss on your initial investment of $50. Plus, you’ll also owe interest on the borrowed funds.
Another risk investors face when trading on margin is the margin call. The Financial Industry Regulatory Authority (FINRA) requires you to keep at least 25% of the total market value of the securities in your margin account at all times. This is known as the maintenance requirement. If your stock loses value and causes your equity to fall below this requirement, you may receive a margin call, which requires you to deposit cash or sell securities to increase your equity.
Before you start investing on margin, it’s important to weigh the pros and cons to determine whether it’s right for you.
Margin accounts: the pros and cons
A margin account has its share of benefits and drawbacks. Although the potential for greater returns is attractive, the downsides of investing on margin make it a riskier option.
Advantages of a margin account
- You have more purchasing power. Investing on margin allows you to purchase stock with borrowed money. This gives you more purchasing power and reduces the amount of cash you need on hand.
- You’ll see potentially magnified returns. Buying on margin makes it possible to amplify your returns more than you could with a cash account.
- You’ll have the potential ability to profit from declining shares. With a margin account, you can short a stock if you believe the price of the stock will decrease in value. This allows you to take advantage of price movements in either direction.
Disadvantages of a margin account
- You can lose more than you invested. Just as profits can be magnified, so too can losses. If you purchase stock on margin and it loses value, you still have to repay the borrowed money plus interest.
- High-interest charges can become cost-prohibitive. Borrowing money comes with the added cost of paying interest. Depending on the interest rate, this can significantly eat into your returns.
- There is an added layer of risk because you’re essentially borrowing cash from a broker. As with any debt, borrowing money adds an additional layer of risk. Your obligation with a cash account ends with the trade execution. With a margin account, you still have to repay the broker the amount borrowed, plus interest, regardless of which direction the stock price goes.
- You may be forced to sell your securities. Your broker may force you to sell the securities in your account if declining stock prices bring your account value too low.
3 tips for minimizing your risk with a margin account
Investing with borrowed money is riskier than using only the cash you have available. If a stock purchased on margin declines in value, your losses can be substantial.
If you decide to trade on margin, here are some tips to minimize risk:
- Leave cash in your account to help reduce the likelihood of a margin call. Be prepared for market volatility by leaving some cash in your investment account, even when the market is fairly consistent. Also, make sure you have cash on hand in case you need to move additional money into your account quickly. Taking these steps may help you avoid margin calls.
- Pay the interest you owe regularly. As mentioned, with a margin account, you need to repay the balance of what you borrow, plus interest. Ensure you’re paying off the interest each month in addition to the principal you owe. Monthly interest charges on margin accounts can add up over time if you aren’t paying down interest regularly.
- Use strict buy-and-sell rules. Because trading on margin can be risky, establishing conservative buy-and-sell rules can help protect your finances.
FAQs about investing in the stock market
Can you lose all your money in stocks?
Yes, you can lose any amount of money invested in stocks. A company can lose all its value, which will likely translate into a declining stock price. Stock prices also fluctuate depending on the supply and demand of the stock. If a stock drops to zero, you can lose all the money you’ve invested.
But don't let the reality of risk scare you away from investing. The best robo-advisors can create a diversified portfolio that manages market risk for you. This doesn't mean you won't lose money in the short term as all investments are risky. Yet diversification will mitigate the risk of losing all of the money you have invested and give your account time to grow and mature over the long term.
Do I owe money if a stock goes down?
If you invest in stocks with a cash account, you will not owe money if a stock goes down in value. The value of your investment will decrease, but you will not owe money. If you buy stock using borrowed money, you will owe money no matter which way the stock price goes because you have to repay the loan.
What happens if a stock goes to zero?
A stock that drops to zero runs the risk of being delisted by its stock exchange. For instance, if a stock trading on the Nasdaq exchange falls below $1 for 30 consecutive days, Nasdaq gives the company 180 days to regain compliance or it faces possible delisting.
What's the difference between a cash and a margin account?
A cash account is a type of brokerage account that requires investors to pay in full for any purchased securities. A margin account, on the other hand, allows investors to borrow funds from the broker to cover the cost of the transaction.
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The bottom line
Any type of investment is subject to some degree of risk, and stocks are no different. Depending on the type of account you use, it’s possible to lose more than you invest in stocks.
For the vast majority of those new to learning how to invest money, a cash account will likely be your best bet. With a cash account, you trade only with the cash you have available, and that should be enough as you’re getting started investing. You might still see great returns, but you don’t carry the risk of magnified losses.
As you learn and gain more experience, you may find that a margin account is a next step in your investment strategy. If you feel comfortable trading on margin, consider starting with small positions at first to limit your risk.
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FinanceBuzz is not an investment advisor. This content is for informational purposes only, you should not construe any such information as legal, tax, investment, financial, or other advice.
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