Thursday, December 11, 2014

How do investors lose money when the stock market crashes?

How do investors lose money when the stock market crashes?
Over the last hundred years, there have been several large stock market crashes that have plagued the global financial system.
Due to the way stocks are traded, investors can lose quite a bit of money if they don't understand how fluctuating share prices affect their wealth. In the simplest sense, investors buy shares at a certain price and can then sell the shares to realize capital gains. However, if the share price drops dramatically, the investor will not realize a gain; in fact, the investor will lose money. For example, suppose that an investor buys shares in a company for a total of Rs.1,000. Due to a stock market crash, the price of the shares drops 75%. As a result, the investor's position falls from 1,000 shares worth Rs.1,000 to 1,000 shares worth Rs.250. In this case, if the investor sells the position, he or she will incur a net loss of Rs.750.
Another way that an investor can lose large amounts of money as a result of a stock market crash is by buying on margin. In this investment strategy, investors borrow money in order to make a profit. More specifically, an investor pools his or her own money along with a very large amount of borrowed money in order to make a profit on small gains in the stock market. Once the investor sells the position and repays the loan and interest, a small profit will remain. For example, if an investor borrows Rs.999 from the bank (at 5% interest) and then combines it with Re.1 of his or her own savings, that investor will have Rs.1,000 available for investment purposes. If that money is invested in a stock that yields a 6% return, the investor will receive a total of Rs.1,060. After returning the loan (with interest), about Rs.11 will be left over as profit. Based on the investor's personal investment of Re.1, this would represent a return of more than 1000%.
This strategy certainly works if the market goes up, but if the market crashes, the investor will be in a lot of trouble. For example, if the value of the Rs.1,000 investment drops to Rs.100, the investor will not only lose the money he or she contributed personally, but will also owe more than Rs.950 to the bank (that's Rs.950 owed on an initial amount of only Re.1 provided by the investor).
Many traders use very large margin positions in order to take advantage of this strategy. However, when a depression hits, these investors worsen their overall financial situations, because not only will they lose everything they owned, they also owe large amounts of money. . In order to prevent such events from occurring again, the Securities and Exchange Board of India (SEBI) made regulations that prevent investors from taking large positions on margin.

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