How to lose all your money in the stock market

It was 1999. I had been on an unbelievable roll for almost two years. Buying stocks, selling stocks. I was regularly going to chat rooms on Yahoo and the Motley Fool investing websites making wild comments.  I was even into exotic investments with names like covered calls, options, and puts. In October of 1999, I had purchased call options on AOL. Not just a few, but a veritable boatload. I knew that these would soar once AOL had its earnings report. I watched my options move up 100%, 200%, all the way up to 500% of my purchase price. I remember my broker calling me and saying, “Your options are worth a million dollars.”

It was a flashpoint in my life. Suddenly I was no longer a physical therapist. I was now an investor. I began to see myself differently. I started making plans for my winnings. I wasn’t alone. Lots of other people thought they were millionaires in 1999. They had convinced themselves that the world had suddenly changed. The internet was the next gold-rush. Everyone was a stock market genius. I loved every moment of it. Suddenly I knew more than anyone. I was the king of chat rooms, shouting down naysayers and cheering on my favorite stocks.  I left my job. I knew we were about to move back to Florida to care for my grandmother . So I thought I would quit early, travel a bit, and then use my winnings to start a new life in Florida. I was living a new life funded by paper winnings.  I just needed to hold the options until the earnings reported in January, then collect my winnings. So foolish!

I got my wake-up call sooner than the rest of Wall Street. In early 2000, AOL announced that it was acquiring the venerable media conglomerate, Time Warner.  In an instant, my call options plummeted. In a day I went from being fabulously wealthy back to just having some assets. But I was lucky, I managed to get my entire AOL investment back plus a small profit. But the pain of knowing that I had made millions only to lose it was overwhelming.

So I tried to make up for it.  Like a fool, I bought options on other internet names. I risked everything to try and make back my ‘lost millions’.  Then came the reality. The very driver that sunk AOL became the reality for anything internet. There was carnage in the street. I lost everything. All the money I had made over the past three years. Everything.

 Investing! Just the word makes me a little excited. I am not sure if you would call it an obsession, a passion, or just a hobby. I have always been involved in the market. At times, it was a distant relationship, where I owned some stocks but wasn’t watching every minute. But for most of my adult life, it has been much more. It was a daily checking, reading, strategizing, and occasional investing. For me, it is like a daily routine. A part of me.  Just like an accent or a hair color is part of someone else. I am an investor.

I had many examples of investors in my own family. I had my mom and dad who swore that bank certificates of deposit were the only real way to find wealth. They were able to retire at 55 on teachers salaries, so it's hard to ignore them.  I had a grandmother  who made a fortune in real estate.  She later kept her fortune in stocks and CD’s. I am sure it was her example that set my mother down a path of eschewing risk and taking the road more traveled. But I also had two uncles who took on risk in the markets and investment and had varying levels of success. There were lots of people right next to me investing. I had been an investor since 1992. I should have known better.

A rational person would have taken my experiences in 2000 and sworn off investing forever. I am not a rational person. I licked my wounds and moved on. I had to get not one but three jobs, but I made things work. I was able to pull us out of debt within a year. Good thing, because we had just had a new baby and we were living in a new home on the east coast of Florida. I worked hard, very hard, to build our assets back. I even began to invest again.

It was not easy to go back into the market. By 2003 the stock market was again showing signs of life. But this time, I had taken the harsh lessons I learned in 2000 and built a better mousetrap. I spent a lot of time looking at my failures. I studied them, not to dwell, but to find out how to improve. I still believed that the stock market was the greatest passive vehicle for our money. But I recognized risk needs to be taken into consideration. There was a great benefit in getting market returns over long periods of time. Cash investments never do as well over 20 year periods. I discovered indexing. I began to build a simple passive investing technique which allowed me to be fully invested at all times yet without the risk of owning just a few stocks in a single sector. The key thing was, my new strategy gave me the will to once again invest. These changes in my investing style had a positive effect on my savings. My money was finally growing.  

Don’t get me wrong, I still take risk. In fact, my investments are still much riskier than the average investor portfolio.  But I have learned that I have to take some risk. To think that you are completely without risk is a fallacy. But I believe that a level of risk is required to keep you away from what I call “flavor-of-the-month” investing. I have come to realize that my personality requires that I take some risk. I think my investment style has more to do with satisfying this need than it has to do with making money. I am sure most of you will see that as an admission of a character flaw. Doug the gambler revealed. Well maybe. I look at it this way, people are often tempted by the next big thing.  

Flavor –of-the-month investors switch from one strategy to another racking up commissions and losses year after year. The investing public is famous for dropping one idea and taking up another, year after year. It's this frenetic investing style that leads to the average investor performing poorly in the market. One year, everyone piles into oil because it did so well the previous year. The next year, emerging market funds are the rage because they returned 70% the year before. Most investors are always too late to the party. They find themselves standing when the music stops. Why do people do this? I think for two reasons, one is a deep feeling they are behind everyone else and need to make up. Second, they are often randomly rewarded for their bad behavior.

In college I studied animal behaviorism. Imagine an animal trained to perform a behavior for a reward.  Day after day, the animal performs the behavior and is subsequently rewarded.  Extinction of behavior  is a test where the animal performs the action over and over without receiving the normal reward. It has been shown that an animal will perform the behavior longer if  he was rewarded intermittently rather than consistently.

 The stock market trains millions of rats every day to be highly resistant to extinction of behavior. You do your research, you prepare, you study the technicalities. You invest. Sometimes, you win. Other times, you lose. Your brain makes a connection between your research, your technical analysis, your preparation and your winning or losing. It's human nature. We may try something and suddenly find ourselves making money. We think this is because we are smart or the advice we took was good. Most likely, neither reason accounts for our success. But we make that connection and it reinforces our bad behavior. We keep switching from investment to investment. Soon our gains are lost in churn and commissions. Sound familiar?

So here is my strategy. I use this for all my retirement accounts and my taxable accounts.Disclaimer: This is meant for illustrative purposes only and is by no means meant to be followed by anyone. I have lost money, you could too. You have been warned.

I invest in only 5 indexes.

VWO  Vanguard Emerging Market Index

VDE    Vanguard Energy Fund

VNQ  Vanguard Real estate invest trust fund

VIG  Vanguard dividend appreciation fund

VB   Vanguard small cap stock fund

I chose these because they all have very low costs, they represent their indexes as well as (or better than) any other fund in their sector, they are somewhat non-correlated, and they all are well traded with good liquidity.

I do one thing that has led to outsized gains for my portfolio.  I only buy shares when they are undervalued. I make quarterly contributions to these funds – yet I do not buy some shares in all these funds equally. Instead, I usually buy which ever fund is down the most. I try and keep about 20% in all of these. So when I have new money to invest, I buy whichever one represents the lowest percentage. That way, if the REIT sector has had a bad year, taking my portfolio percentage down to 12% (as happened in 2008), then all my new money would purchase this fund until it came up to 20%.  

Here is my assumption: none of these indexes will ever disappear. They will always exist, but will also always cycle. There are times when energy or emerging markets are down. That’s when you want to be a buyer. There are times when small cap is soaring. That’s when I want to either sell some to reinvest in a lagging fund or just use new money to even things out. So how well have I done? Very well. I am not going to post my percentages, because I only think they will encourage the wrong kind of behavior. I promise to revisit this topic in more detail in the future, and you are welcome to ask me more questions. I can tell you, I have seen double digit gains over the S&P using this technique. It is risky, and at times my portfolio drops. But I am happy with this level of risk because I have faith that there will be an outsized payoff from sticking with it. It keeps me from making foolish moves and following the herd off the cliff.

Doug