Investing in stock is financially dangerous. While it's certainly possible to make a profit, it's also extremely easy to lose a lot of money. Although I own some stocks and manage my portfolio myself, I don't generally advise people to enter the stock market.

Here are a couple danger flags that come to mind when I think of stocks.


The stock market is rigged.

You think the stock market is you against a million other investors, and if you're smarter, you'll win.

It's not. It's you and a million other investors against the house, and the games are rigged.

For example, suppose you decide to buy 100 shares of XYZ stock. You browse to your broker and enter your order. You assume the broker matches you up with someone who wants to sell XYZ stock, and the price is set by supply and demand market forces.

Wrong. This direct match-a-buyer-to-a-seller market method was tried in the beginning and found to result in roller coaster volatility. Small changes in supply and demand drove huge price swings and scared investors out of the market.

So a new system, called the "specialist system", was implemented. In this system, a person called a specialist (or "market maker", for NASDAQ stocks) participates in every trade, and directly controls the price. When you buy your 100 shares of XYZ, you're buying them from the specialist. Where did the specialist get them? He bought them from another seller. And in both the buy and the sell, the specialist decided what the price would be.

How does the specialist decide on a price? In theory, his job is to stabilize the market by choosing a price that balances supply and demand, even if this price means the specialist has to lose money by buying high and selling low. But this definition has a lot of latitude, and the specialist has a lot of influence over buyers and sellers, and this job has a lot of temptation. A skilled specialist might manipulate the market up and down with the goal of buying low and selling high, limited only by his obligation to meet certain stability requirements.

When the specialist buys low, he is buying from us, who are therefore selling low. When the specialist sells high, he is selling to us, who are therefore buying high. The specialist has access to the company's inside information not available to the public. He has access to news before it broadcasts. He sees exactly the supply and demand at every moment. And he has spent his entire professional life refining his skill at making money under these circumstances. No wonder NYSE seats sell for such outrageous prices. It's an absolute gold mine.

The market is rigged.


Investing is very emotional, and an investor's emotions deceive.

Ironically, when it comes to investing, our emotions drive us to do exactly what loses money, and exactly the opposite of what we might know to be smart. And even for reserved, unemotional people, once we have our money in the game, emotions can grow to be an extreme force in the money-losing direction.

Everyone knows it's smart to buy low and sell high. And we all know that, for the most part, stocks don't continually go up or down, but they go up for a while, then down for a while, then repeat the cycle. But what happens when a stock we own drops too much? Our emotions tell us, "this stock is a loser -- we must get rid of it, at any price". And remarkably, this emotion is often strongest precisely at the lowest price the stock will achieve before returning to normal.

What about when a stock we follow but don't own rises? Our adrenaline rises as we watch, and again, it often peaks along with the stock price. Similar phenomena induce us to hang on too long to a stock that is falling because of a good fundamental reason.

Keeping one's mind, rather than one's heart, in charge of investing decisions does not come naturally, even for otherwise emotionally in-control people. Don't underestimate the bad influence of one's own emotions on investing. Even though you know this, it will likely happen to you if you enter the market.


Diversify.

Diversify means don't buy too much of any one stock (or other investment vehicle); instead, buy small lots of a variety of stocks. That way, if unpredicted disaster strikes one stock, it only hurts you a little, it doesn't wipe you out.

Some years ago I had a 401k that had a large block of stock in a former employer. An investment counselor told me that I had too much of my money in that one stock, and advised me to sell off most of it and diversify. Reluctantly, I sold 80%, keeping only 20%. Then the company went bankrupt in Enron-like fashion. Today, the 20% that I still own is worth 28 cents. I'm very glad I followed my counselor’s advice and diversified.

Tags: investing, stock