This Month in Money Mistakes

You ever see something online that makes your guts shrivel?

I feel that way pretty frequently whenever I peruse financial subreddits. 

[If the words “financial subreddits” means nothing to you, Reddit is a popular online messageboard. People post notes, messages, images, videos. Then people comment in response. A subreddit is a topic-specific messageboard.]

These became popular in the media when members of a subreddit called “WallStreetBets” began making an extraordinary amount of money making absurd bets on stocks like GameStop and AMC… and in the process, causing hedge funds and market makers to lose billions of dollars. 

The “how and why” of that is long and complicated and also resulted in me making $20,000 and buying all my friends chicken tenders… but that’s a story for another time. 

Today, instead, I want to draw your attention to two posts I spotted in the wild this month that just… hurt my soul. 

As I’ve said before, the mentors in your life can be good examples or horrible warnings.

So let me share with you two horrible warnings… and see what we can learn from them.

“I have money in an IRA. Why isn’t it growing?”

Hi, I started a Roth IRA in January this year. I put in $6000 for 2020 and $1000 for this year. I'm going to contribute the other $5,000 soon. I am wondering why nothing has changed? Here is a screenshot of my account:

(I'm not sure where the $0.55 is from).

I also have a Traditional 401k through my employer, Merrill and Lynch. I can clearly see the amount I've contributed, as well as the losses/gains from the market.

What am I doing wrong with Vanguard? [link]

This poor soul thought an Individual Retirement Account (IRA) was an automatic money machine. 

They put money in. But they don’t understand why it’s not growing.

Unfortunately, this poor soul is one of many. 

I know a number of people who think this is the case with IRAs, 401(k)s, 529 accounts, HSAs, ISAs, etc.

And it’s understandable… this alphanumeric soup of different retirement accounts is confusing as heck!

So let me give you a simple question to ask if you’re going to open any retirement account with any institution:

“Do I have to invest myself, or is it done for me?”

In the case of the poor poster above, she or he had a 401(k) that was automatically invested, likely in a mutual fund chosen by the institution or their employer. (These usually come with high fees that can diminish your future returns and underperform the market.)

This gave them the wrong impression that this is the way it’s always done.

Now that they also have an IRA, they wrongly assumed the same.

“Put money in. Money invested for me. I make more money. Hooray!”

Which in a way, that’s sort of true…

That’s where the poster’s $0.55 came from. 

If you store money in an online brokerage, it will typically be invested for you in what’s called a Money Market fund, that will earn 0.01% to 0.05% interest each year.

(This is because the bank uses your money to invest in so-called “risk-free” securities, such as overnight repos, which is such a bizarre and complicated asset that you should waste none of your mental bandwidth trying to understand them.)

But if you want to make money in your IRA? 

You have to choose to invest by buying assets. 

That could be a low fee fund that tracks the overall market, like:

• The SPDR S&P 500 ETF Trust (SPY)

• The SPDR Dow Jones Industrial Average ETF Trust (DIA)

• The Invesco NASDAQ 100 ETF (QQQM)

It could also be a high-dividend, low-volatility ETF like the Invesco S&P 500 High Dividend Low Volatility ETF (SPHD)...

It could be an atypical asset class, like the iShares Preferred and Income Securities ETF (PFF)...

Or it could be a ridiculously safe asset (if you believe in America’s economic stability), like the iShares 20+ Year Treasury Bond ETF (TLT). 

The cool thing about these index-based assets is that you can invest a little bit at a time…

Which will average out your costs. (This turns downturns into opportunities for you.)

And if there’s ever a stock that goes bankrupt or no longer meets the index’s criteria?

You’re not at much risk, because the index will kick the bad stock out for you. And it will pay you income just for owning it.

But if making money passively and steadily over time doesn’t appeal to you…

Here’s a more active strategy that has outperformed the market over time:

Put some (let’s say about 10%) of your cash into an index ETF every time its price drops by -1% or more over the course of a month.

Do this with $100 over the last 20 years and you would have earned a cool 309.5% return.

You can also do this with a specific stock you have a lot of faith in…

But it takes less information and vigilance on your part to invest in funds. At least until you learn more about investing.

If you put all your money into a stock or complicated asset like a derivative, you might end up like this next poster…

“I lost my life savings betting everything on risky options for a speculative stock. What did I do wrong?”

[link]

So let me explain what you’re looking at in the images above…

This poster is 19 years old. Works at Costco. Lives in a trailer with his mom.

As he said in the comments of this post, he “Started w 17k made it to 50k in options and then lost it.”

And you know… good for him. 

Not only did he save his money, he will hopefully learn an expensive lesson about trading. 

Though it’s doubtful he’s learned anything yet, since in one of his comments he said, “I gained a little of it back hopefully pltr hits 21 so I can be rich again.”

(Basically, because of the nature of his bet, if PLTR trades below $21 by the end of December 17, this poster will owe everything and more of what they initially invested.)

It’s situations like this that lead to tragedies like Alex Kearns, who killed himself after doing essentially the same things.

Doing this isn’t just how you end up losing everything, it’s how you, like the original poster, end up losing -148% of your investment.

Everything this poster and poor Alex did wrong can be summed up in one sentence…

Using margin to YOLO selling call options on a volatile stock. 

Let me break that sentence down so you can avoid the same mistake yourself…

“Using Margin”: This is a loan your brokerage account gives you if you don’t have enough money to buy what you want, or buy more of what you want.

Like any loan, you owe interest on the money you borrow. 

Experienced investors can use margin to “short a stock” (make money when a stock goes down) or cover some portion of the collateral needed to make an option trade (more on that in a moment). 

If your trade looks like it’s going to lose a ton of money…

Your brokerage steps in like a referee to stop a fight if it’s getting too bloody.

This is called a “margin call,” and it means you have a limited amount of time to invest more money to cover your losses or get out of your trades before the brokerage account does it for you.

Margin is basically a bad idea for someone who doesn’t know what they’re doing (or simply thinks they know).

But here’s a simple way to profitably use margin:

Many brokerages charge a margin interest rate of 0.75% to 2.5%. 

If you buy a stock or index fund that pays a dividend yield greater than the margin cost, then you get to keep the difference. 

This works… so long as what you buy doesn’t sharply decrease in value. 

“YOLO”: Short for “you only live once,” this is where you put all your money (or an absurdly large portion of your money) into one stock trade. 

It is the investing equivalent of taking your entire net worth into a casino and betting everything on a single hand of Blackjack. 

I hope I don’t need to tell you how ridiculously stupid this is, and how disappointed I would be if you did this.

There is no bet in the stock market so certain that you are guaranteed to make money… And most of these are entirely outside of your control. 

That’s especially true with options.

My recommendation? 

Do what you can to get even just a little bit richer every day…

And allocate your assets intelligently (I’ll have some advice on that shortly).

“Options”: Stock options were originally designed to reduce risk, but many people have begun trading them in the riskiest way possible. 

A stock option is basically a contractual bet on whether a stock be above a specific price by a specific date. 

It’s essentially insurance on your stocks: If something happens, you get paid. If not, you lose the money you paid for the insurance.

Now here’s where options get more complicated…

You can buy this insurance on your stocks. If you buy a “put option,” you pay a price (called a premium) to bet that an underlying stock will go down below a specific price of your choice (called the “strike price”) before a certain expiration date. 

Buying a “call option” is a bet that the stock will go above the strike price.

If you buy an option and it expires without your bet coming true, it expires worthless. You lose 100% of the premium you paid. 

If the terms of your bet come true, though…

Say if you buy one call option for IBM at the $120 strike price, expiring January 21, 2022… and you pay $3.00 per share or $300 in premium… And the stock goes to $130 at any point before January 21…

Your option value will grow from $300 to $1,000, more or less. 

Why more or less? Because option prices factor in 1) the change in price of the stock, 2) the volatility (uncertainty) of the stock, 3) how close we are to the expiration date, 4) whether the stock pays dividends, 5) the interest on treasury bonds.

The math looks like this: 

Basically, unless you want to get elbow deep in differential calculus, you’re not going to have a full understanding of what your option will be worth at any particular point in time. 

You can buy an option that goes above your strike price… and still lose money.

(If you’re deadset on buying options, though, here’s a free calculator that might help you assess your option bets.)

Here’s the thing, though…

You can also SELL this “insurance” to other traders. 

You get to collect the cash of the option premium in exchange for buying shares of a stock (in the case of a put option) or selling your shares of a stock (in the case of a call option).

If you’re selling put options on stocks you WANT to own regardless of the price, and you have the cash available to cover the purchase, then you’re probably fine. This is actually a great way to earn extra income and build a long-term portfolio over time.

But if you’re selling call options… and you don’t own all the shares covered by the contract you’re signing because you’re trading on margin?

Well, this is how you end up losing -148% of your investment and get someone like me making fun of you on the internet.

Long Story Short…

There’s a lot of overlap between wealth, health, and knowledge…

And the best way of building all three is to start small, with stuff you can easily grasp, and progress steadily as far as you wish to go. 

You don’t need to know how to solve a partial differential equation to make money in the stock market…

You don’t need to know how to value a stock to make money in the stock market…

The same way you don’t need to know how to a snatch-grip deficit deadlift to begin working out and getting fit.

Next week, I’ll try to follow through with what I said above and give you some insights into asset allocation…

So you know what you should be investing in, depending on how much wealth you have.