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Janet in Trading psychology,

What will you do if the market falls?

How to avoid self-destructive investing

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Running for the exit isn’t always the right move.

During a stock-market decline, there are those who panic and sell. And then there are those who don’t have any choice.

In late 2008 and early 2009, I remember talking to many investors who lost their nerve as share prices plummeted. Some of those who dumped stocks were folks I considered to be seasoned investors.

But today’s column is aimed at a different group: those who set themselves up for failure before share prices even decline — by pursuing high-risk investment strategies that just don’t make sense for the typical investor.

Flirting with zero

Let’s say you take out a margin loan, which involves borrowing against your portfolio’s value. You then use that money to buy additional shares, so you end up owning, say, twice as much stock as you could otherwise afford.

That leverage should prove mighty rewarding if shares rally from here. But if, instead, stocks tumble, you could get a margin call demanding that you repay part of the loan. At that point, you might be forced to sell shares and give up all chance of recouping your losses. In a sign of the market’s frothiness, margin borrowing has doubled since the start of 2010.

Selling put options can also lead to permanent losses. When you sell a put, you receive a premium from the option’s buyer. In return, you give the buyer the right to sell you shares at a specified price. If the stock falls far below that price, you will lose a fistful of money—and the premium received will be scant compensation.

You could also suffer large, permanent losses if you bet heavily on a few stocks. While it’s reasonable to expect the broad market to rebound from a severe decline, there are plenty of individual stocks that plunge and never recover. Just think about all the dot-com companies that went out of business during the 2000-02 bear market.

In addition, I would be leery of leveraged stock funds. For instance, ProShares Ultra S&P 500, an exchange-traded fund that aims to deliver twice the daily return of the S&P 500-stock index, lost an eye-popping 84.7% from 2007’s market peak to 2009’s trough, according to Chicago investment researcher Morningstar.

Amazingly, the fund eventually recouped that loss, though it’s hard to imagine many shareholders toughed it out through the entire roller-coaster ride.

Keep in mind that such brutal losses aren’t just a bear-market phenomenon. In a rising market, there are other strategies that also offer the prospect of staggering losses. Suppose you borrow shares and then sell them short, in a bet that they’ll fall in value. If, instead, the stock rallies, there’s no limit to your potential loss.

http://www.marketwatch.com/