I have seen many people showing a concern that they have heard the stories of investors who have lost all of their investment in stock market i.e. loss of -100%. For them stock market is all about losses. People need to understand that the true question to be asked is not how much they have lost but it should be how did they loss. What strategy they were using? What investments they were making?
In order to elaborate my point further, let me tell you three primary risks through which investors loss all of their invested capital:
1. The company in which you invested gets bankrupt.
2. Use of leverage (loan).
3. Counterparty risk.
The first risk can best be explained through an example. Suppose you have 100,000 PKR and you invest all of your money in a hypothetical company Best Company Ltd. After one year, the company gets bankrupt and you lost your entire invested amount. Now, that investor may complain that market is a “bad” place for investment but the thing that we need to realize is that it was the company that was “bad” and not the market. There are 100 companies in KSE 100. Can you loss all of your investment if you invest 1000 in each company (1000*100= 100,000). Can 100 companies go bankrupt? They surely can but the probability of this event is almost negligible. Put it simply, if you divide your investment in many companies (say 15) and even if one of them gets bankrupt you still are safe and lost only 6.67%(1/15) and given a fact that market average return is around 20-25% you still must be making a good amount of money. There is no chance that you can loss all of your investment if you diversify your portfolio.
The second risk can also be explained best through an example. Suppose you have PKR 25 and you borrow PKR 75 from your broker so you invested capital is PKR 100. Suppose market goes down by 25% and as a result, your invested capital lost 25% as well meaning you invested capital now decreased to PKR 75 now. At this time, your broker will take his money back or ask you to invest additional capital and if you do not have additional capital he will surely take his money back. What do you have now? Actually, you have lost all of your investment. Even though market lost just 25% but you lost 100% of your amount. Why? Because you used the leverage. If you had not used the leverage you would have lost only 25% and your invested capital would have been PKR 18.75. As you can see, the sole reason of “100% loss” was leverage. If after this loss, you say, “Market is bad” then you are wrong. The true comment should be “leverage is bad” or more appropriately “you did not realize the risk of using leverage”.
Now we come to the third risk and this is the risk most relevant to an emerging country like Pakistan. Counterparty risk means your broker do not have an ability or intention to pay back your money. These frauds have occurred in KSE (although KSE has paid back some of the lost amount to investors) in past, however rules and regulations are now being enforced and the advent of “CDC” is the proof of this. In fact, stock market has become the most heavily regulated industry of this country and this means that counterparty risk has been minimized. However, in order to avoid this risk investor should open his account in a renowned brokerage house and which has the history of best ethical practices.
After reading this article if any one tells you that he has lost all of his investment in stock market you should ask these three questions of him:
1. Did you invest majority of you investment in just one company?
2. Did you use leverage?
3. Did you have an account with a small brokerage house?
If the answer of any of these questions is yes, then whose fault is it? Of market or of investor? Believe me 99% of investors who have lost all of their investment did not diversify their portfolio, or did use leverage or did not have enough knowledge about their broker.
Good luck with your investments!
In order to elaborate my point further, let me tell you three primary risks through which investors loss all of their invested capital:
1. The company in which you invested gets bankrupt.
2. Use of leverage (loan).
3. Counterparty risk.
The first risk can best be explained through an example. Suppose you have 100,000 PKR and you invest all of your money in a hypothetical company Best Company Ltd. After one year, the company gets bankrupt and you lost your entire invested amount. Now, that investor may complain that market is a “bad” place for investment but the thing that we need to realize is that it was the company that was “bad” and not the market. There are 100 companies in KSE 100. Can you loss all of your investment if you invest 1000 in each company (1000*100= 100,000). Can 100 companies go bankrupt? They surely can but the probability of this event is almost negligible. Put it simply, if you divide your investment in many companies (say 15) and even if one of them gets bankrupt you still are safe and lost only 6.67%(1/15) and given a fact that market average return is around 20-25% you still must be making a good amount of money. There is no chance that you can loss all of your investment if you diversify your portfolio.
The second risk can also be explained best through an example. Suppose you have PKR 25 and you borrow PKR 75 from your broker so you invested capital is PKR 100. Suppose market goes down by 25% and as a result, your invested capital lost 25% as well meaning you invested capital now decreased to PKR 75 now. At this time, your broker will take his money back or ask you to invest additional capital and if you do not have additional capital he will surely take his money back. What do you have now? Actually, you have lost all of your investment. Even though market lost just 25% but you lost 100% of your amount. Why? Because you used the leverage. If you had not used the leverage you would have lost only 25% and your invested capital would have been PKR 18.75. As you can see, the sole reason of “100% loss” was leverage. If after this loss, you say, “Market is bad” then you are wrong. The true comment should be “leverage is bad” or more appropriately “you did not realize the risk of using leverage”.
Now we come to the third risk and this is the risk most relevant to an emerging country like Pakistan. Counterparty risk means your broker do not have an ability or intention to pay back your money. These frauds have occurred in KSE (although KSE has paid back some of the lost amount to investors) in past, however rules and regulations are now being enforced and the advent of “CDC” is the proof of this. In fact, stock market has become the most heavily regulated industry of this country and this means that counterparty risk has been minimized. However, in order to avoid this risk investor should open his account in a renowned brokerage house and which has the history of best ethical practices.
After reading this article if any one tells you that he has lost all of his investment in stock market you should ask these three questions of him:
1. Did you invest majority of you investment in just one company?
2. Did you use leverage?
3. Did you have an account with a small brokerage house?
If the answer of any of these questions is yes, then whose fault is it? Of market or of investor? Believe me 99% of investors who have lost all of their investment did not diversify their portfolio, or did use leverage or did not have enough knowledge about their broker.
Good luck with your investments!
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