Let the IRS Help Your Investment Returns

Income taxes can take a serious bite out of your savings and investment plan. Fortunately, the federal government is well aware of this, and gives taxpayers a break in the form of several IRS-approved tax-deferred investment plans. These investment vehicles allow you to put money away for your retirement and not pay any taxes on your gains until you begin to make withdrawals when you’re in your 50’s or later. This allows the magic of compound interest to go to work for you, earning you interest on top of interest. It’s an extremely effective way of building your financial nest egg. With an Individual Retirement Account (IRA) you can invest up to $4,000 per year in virtually any type of security instrument you choose, from a bank Certificate of Deposit to individual stocks to mutual funds. Just tell the financial institution that you want your investment to be sheltered in an IRA. You must report your investment on your tax return, but you don’t have to pay any taxes on your gains until you begin to withdraw the funds at retirement age. If you have a spouse who doesn’t work, you can also open a Spousal IRA and contribute up to an additional $4,000 per year into it. The 401(k) is a qualified plan (which means it meets the requirements of the Internal Revenue Code) that’s established by employers into which eligible employees can make salary-deferral contributions. In other words, the contribution comes directly off the top of your paycheck without your ever seeing the money. This makes saving and investing automatic, eliminating the need for you have to decide if you’re going to save each month. The biggest benefit of a 401(k) plan is that many employers will either match or partially match your contribution, which means you get a pretax investment, tax-deferred compounding of your interest earned, and an extra addition to your principal from your company (essentially, free money). This allows the value of your investment to grow at an even faster rate. Nonprofit employers offer a similar plan called the 403(b). It’s basically the same arrangement as the 401(k); the difference in name derives from it being part of a different section of the Tax Code. An Annuity is a bit like a combination of an IRA and a life insurance policy. Like an IRA, an annuity allows you to earn interest and capital gains on your investment without paying any taxes until you begin to withdraw the funds at retirement age. And like an IRA you’ll face a 10% penalty if you withdraw before your eligible age. But unlike the IRA, you can make virtually unlimited contributions yearly. Those contributions, however, are with after-tax dollars, so you don’t get the tax deduction benefit that’s available with the IRA or 401(k). But since an annuity is basically a quasi-insurance vehicle, once you begin withdrawing your money (or, annuitizing), you’re guaranteed to receive an income for the rest of your life. In other words, you’ll never outlive your retirement funds.

Long, Short, Flat: What Your Position Means

The terms "long", "short", and "flat" identify an investor's market position with respect to a given stockbroker. To be long means to have a positive market position; in other words, the investor owns a particular security. He is therefore "long" any securities that his brokerage firm is holding for him. If the investor orders the broker to buy 1,000 shares of Widget, Inc., for example, he "goes long" immediately after the trade is executed for him. His account remains "long 1,000 Widget" until the investor either asks the broker to forward the stock certificates to him, or to sell the shares. If all shares are sold while they're in the possession of the broker, the investor's account will become flat (or, a zero position). The sell trade "flattens" his position. The position will also become flat (as far as the investor's account with the brokerage firm is concerned) if the investor asks to take physical delivery of the shares. The shares are transferred to the investor's name and forwarded to him (this cannot be done in margin accounts). The account documentation will read "delivered 1,000 Widget", or "1,000 Widget del". The word "flat" does not appear on the account statement; it's simply the broker's signification that no shares are owed to the investor. A partial reduction of the shares held by the brokerage house does not flatten the account. For instance, if the investor is long 1,000 Widget and sells 500 shares, his long position is not flattened, but simply reduced to 500 shares. Additionally, if the broker sends 200 of the remaining 500 Widget shares to the investor at his request, then the long position is further reduced to 300 shares. The investor's long position reflects only his standing with the particular brokerage firm, since the firm has no way of knowing what shares the investor might have at home, with other brokerages, or with banks. If the investor sends the brokerage firm stock to be held in his account, the transaction is posted as a "receive". Therefore, purchases and receives will create or increase long positions; sales and delivers reduce or eliminate long them. All of the investor's individual positions are kept separate by the broker. For example, if the investor owns 500 shares of HIJ stock, 600 shares of MNO, and 700 shares of UVW (a total of 1,800 shares of the three different stocks), the brokerage account will not show the position as "long 1,800," but will rather show "long 500 HIJ; long 600 MNO; long 700 UVW". Stock that's been borrowed to complete a short sale will result in a negative, or short, position. Since a short sale is the sale of something that the investor doesn't own, after the sale the stock is owed to the person or entity from which it was borrowed. Until the shares are returned to their owner (with the use of a 'buy' transaction to cover them), the investor remains short that position. Some active investors' trading accounts have both long positions (where the customer is bullish and expects the long stocks to go up in price) and short positions (in which the customer is bearish on the short stocks and expects their prices to fall) at the same time. Short sales may only be executed in a margin account.

Limiting your Risk with Market-Neutral Investing

Market-neutral investing is an investment strategy that helps you manage risk. It offers protection against market volatility by utilizing simultaneous long (buying securities) and short (borrowing securities in order to sell them) market positions, or by using options or index funds as a hedge. Thus, a market-neutral portfolio would consist of long positions that would be expected to perform well if the market is strong and short positions that would profit if the market does poorly. The theory behind this strategy is that if the market does well you'll make money on your long position, and if it does poorly you'll make money from your short position; you therefore have some protection against loss either way the market moves. You don't know which way the market will go; but if you believe, for example, that there's a 70 percent chance of it going up, you might invest 70 percent of your portfolio into long positions and 30 percent into short positions. Or, because short selling can be extremely risky, as an alternative you could invest the 30 percent in defensive stocks such as food and beverage producers and pharmaceuticals that generally do well in any economy. You hedge both your positions so that whichever one is wrong, you have protection with the other. In other words, you're neutral to the market. When using market-neutral investing, stock selections should be based on the state of the current economy. For example, during periods of low interest rates, construction and housing stocks traditionally do well. Therefore, most investors would typically take long positions in those stocks. However, a market-neutral investor would go a bit farther and look for stocks to short that would likely do poorly if the particular market turned sour, which in this instance might be brokerage stocks. Or he could possibly consider using options of stocks as a hedge, which might be less expensive and certainly less risky than short selling. The market-neutral strategy can be applied to any investing style. A value investor, for example, might buy undervalued stocks and short stocks considered overvalued. A growth investor could buy high-growth stocks and short those with opposite traits. A momentum investor may buy stocks just beginning their upward movement and short stocks that have a downward momentum. It must be remembered that the market-neutral strategy is not designed to speculate on the short side; the primary objective of the short position is not to make money but to help provide protection in the event of a market reversal. It is first and foremost a method of managing risk. As such, not only must you consider your long positions, you must also study your short or defensive positions very carefully. Each scenario must be evaluated closely to ensure that you've chosen the best possible combination of stocks. Because of this, market-neutral investing could potentially double the amount of time that you'd normally spend selecting stocks because you must eye both sides of the equation. You must be prepared to devote the time and energy necessary to do it correctly.

Margin Accounts

For the average person, the purchase of a home or automobile is usually made using a small amount of personal funds and a much larger percentage of money that's borrowed from another source. Most investment securities can be bought in exactly the same manner. When an investor decides to buy securities on margin a special account, known as a margin account, must be opened with a stock brokerage firm. The investor supplies a down payment and the firm lends the remaining balance for the transaction and actually purchases the securities for the investor. Up to 50% of the purchase price of securities bought in this manner can be borrowed funds. The investor can therefore buy up to twice as much market value of stock on margin as is possible using his or her own cash (for those securities which can be bought on margin; not all can). This use of borrowed funds to increase the percentage of profit is known as leverage. This leveraged position creates for the investor an opportunity to make more money for a given sum of investment dollars. At the same time, however, it creates the opportunity for losses which are not limited to the initial investment. These losses can occur very quickly and be quite extreme. Another consideration in margin trading is that interest is charged by the broker on the borrowed funds (known as the debit balance), which can be substantially more than the dividends and interest being earned by the purchased securities. Margin trading is a relatively sophisticated market technique and must be approached with great care. Due to the leveraged position, although greater gains can be achieved than will full cash transactions, the investor is exposed to the risk of deep losses. If the market value of the margined securities drops significantly, the brokerage firm will issue a maintenance- or margin call, which is a demand that the investor deposit more collateral money into the margin account. If the investor cannot or chooses not to deposit more funds, the broker will sell some or all of the securities to bring the account back to a properly margined condition. Normally these forced sales are executed in rapidly falling markets, which actually serves to "lock in" the investor's losses. Securities purchased on margin are not forwarded to the investor. They remain with the brokerage firm as collateral for the debit balance. Such securities are said to be in street name; they're held by the broker in the broker's name (the registered owner), but the investor is the true or beneficial owner. The brokerage firm sends the investor a monthly statement of the account showing the securities and cash that are being held for the investor (this is done for cash accounts, as well). The account will refer to the investor's position as "long" or "short": "long is a positive position in which the investor owns a particular stock; "short" refers to the position of owing stock which was borrowed to complete a sale. Trades are posted to the account on the settlement date (the date that the purchased securities must be paid for), which is generally three business days after the actual trade date. For options and government securities, the settlement date is normally the next business day.

More Key Market Indexes

Over the years, the number of market indexes has grown substantially. For instance, in addition to its industrial average, Dow Jones & Company itself now publishes a transportation average, a utility average, and a composite of all three. Some of the more widely-known indexes are listed below: American Gas Association (AGA) Stock Index - The AGA Stock Index contains approximately 100 publicly-traded stocks of companies engaged in the natural gas distribution and transmission industry. Dow Jones Transportation Average (DJTA) - This index is a price-weighted average of the stocks of 20 large companies in the transportation business, including airlines, railroads, and trucking. Created in 1884, this is the oldest U.S. stock market index. Dow Jones Utility Average (DJUA) - A price-weighted average composed of 15 geographically representative and well-established gas and electric utility companies. Dow Jones Composite Average - This index is a composite of the DJIA, DJTA, and DJUA component stocks. Because it's a combination of the three blue chip averages, it gives a good indication of the overall direction of the largest, most established companies. Lehman Brothers Aggregate Bond Index - This index measures total investment return provided by a wide range of fixed-income securities, weighted by the total market value of each. It is generally considered to be the best bond index, and is used by more than 90 percent of U.S. investors. Morgan Stanley Capital International Europe Index - A diversified, market value-weighted index comprising over 500 companies located in 15 European countries. The U.K., France, and Germany make up approximately two-thirds of the index. Morgan Stanley Capital International Pacific Index - This is a diversified, market value-weighted Pacific Basin index consisting of approximately 500 companies located in Australia, Japan, Hong Kong, New Zealand, and Singapore. The Japanese stock market represents about three-fourths of the market value. Morgan Stanley Capital International Europe, Australasia, and Far East Index (MSCI EAFE) - A broadly-diversified international index consisting of equity securities of companies in 21 developed markets outside the of U.S. New York Stock Exchange Composite Index - A market value-weighted index which includes all stocks traded on the New York Stock Exchange (NYSE). Schwab 1000 Index - This index consists of the common stocks of the 1,000 largest U.S. corporations as measured by market capitalization. Standard & Poor's 500 Composite Stock Price Index - The S&P 500 measures the total investment return of 500 common stocks, which are chosen by Standard & Poor's Corporation on a statistical basis. The 500 securities, most of which trade on the NYSE, represent about 70 percent of the market value of all U.S. common stocks. Typically, companies included in the S&P 500 are the largest and most dominant firms in their industries. Wilshire 5000 Index - This market capitalization-weighted index consists of all publicly traded U.S. stocks, and provides an overall view of the U.S. stock market. More than 6,000 equities are included in the index. It's used to measure the performance of stocks as a whole, as opposed to a particular segment of the stock market.

Market Indexes – The Dow Jones Industrial Average

Market indexes show the general direction of fluctuations in the securities markets and reflect the historical continuity of security price movements. While this information will not necessarily reveal whether individual securities are up or down, it's nevertheless useful to understand how indexes operate because they're commonly used as benchmarks for judging the performance of stocks, bonds, and mutual funds. In actuality, market averages are no longer truly averages anymore. The term index is more appropriate, because the numbers given – usually called points – are not dollar-per-share prices of stocks. Points refer to units of movement in the average, which is a composite of weighted dollar values. Indexes track stocks in particular industry sectors, markets, or capitalization ranges. For instance, one index tracks gold stocks; a different index tracks stocks of companies engaged in the distribution and transmission of natural gas. An index exists for each of several exchanges where stocks are traded, including the New York Stock Exchange (NYSE), the American Stock Exchange (AMEX), and the Over-the-Counter Bulletin Board (OTCBB). One index tracks small capitalization stocks, one tracks large capitalization stocks, and another tracks all stocks traded in the United States. An index is referred to as being price-weighted when it's weighted by the market price of each security included in the average. Thus, securities with high market prices will be more heavily weighted and have more influence on changes in a price-weighted average. The Dow Jones averages are examples of price-weighted indexes. Conversely, an index is said to be market value-weighted when it's adjusted according to the market value of each security included in the average. The greater a firm's number of shares outstanding and the higher the price of the shares, the greater the weight of that security in a market value-weighted average. The S&P 500 index is a market value-weighted index. The best-known and most widely quoted index is the Dow Jones Industrial Average (DJIA), published by Dow Jones & Company, often referred to simply as "the Dow." It's also the most widely used stock market indicator, although the S&P 500 has also become an important standard for many. The DJIA is a price-weighted average of 30 actively traded blue chip stocks consisting primarily of industrial companies. The components represent between 15 percent and 20 percent of the market value of NYSE stocks. It's calculated by adding the closing prices of the component stocks and using a divisor that's adjusted for stock splits and dividends, as well as for substitutions and mergers. The average is quoted in points, not dollar values. As of this writing, the Dow Jones Industrials includes the following companies: 3M Co. E.I. du Pont de Nemours JP Morgan Chase & Co. ALCOA Inc. Exxon Mobil Corp. McDonald's Corp. Altria Group Inc. General Electric Co. Merck & Co. Inc. American Express Co. General Motors Corp. Microsoft Corp. American InternationalHewlett-Packard Co. Pfizer Inc. AT&T Inc. Home Depot Inc. Procter & Gamble Co. Boeing Co. Honeywell International United Technologies Corp. Caterpillar Inc. Intel Corp. Verizon Communications Citigroup Inc. IBM Corp. Wal-Mart Stores Inc. Coca-Cola Co. Johnson & Johnson Walt Disney Co. The Dow is a statistical compilation that reflects combined, not individual, performances. The two great advantages of the DJIA are simplicity and continuity. The present high level of the average is a result of its continuity. Its base has actually never changed; to do so would, in effect, start a new average. One criticism of the DJIA is that it exaggerates market movements because it is described in points and runs more than 100 times the straight average price of industrial stocks. Over the years, stocks have been split, but the Dow has not. It has been suggested that Dow Jones split the industrials, or move the decimal point one place to the left. The prevailing opinion, however, is that the average moves up or down strictly according to arithmetic. If the math were changed, continuity – which is the one of the average's greatest advantages – would be lost. It must be remembered that the market "averages" are no longer really averages, although they were originally and still are referred to as such. Although they are certainly useful measures of the overall movement of the stock market, the numbers themselves must not be confused with the dollar-per-share prices of stocks. This applies not only to the DJIA but to all other stock indexes as well. The reason for the disparity can be found in stock splits, which occur when a company believes that the per-share price of its stock is too high for broad investor appeal. The company then arbitrarily splits the high-priced shares, creating more lower-priced stocks. For example, if a stock selling for $100 is split two-for-one, the new share price would be $50. Of course, each owner of the old $100 stock must be given an additional share of stock for every original share so that the value of his or her holding will not be reduced. Stock splitting, which occurs yearly, would distort the averages unless statistical market value-weighted adjustments were not made to compensate for them. Thus, the Dow Jones averages are not dollar averages of current market prices but movement indicators, kept essentially undistorted for more than a century. Originally consisting of 12 stocks in 1896, the DJIA was increased to 20 in 1916 and then to its present level of 30 in 1928. Whenever any particular component stock for any reason becomes unrepresentative of its industrial sector, a substitution is made and the average adjusted, just as when a split occurs. Critics sometimes charge that the DJIA includes only 30 companies and therefore fails to reflect the movement of hundreds of other stock prices. But these 30 securities are chosen as representative of the broad market and of American industry. The companies are major factors in their industries, and their stocks are widely held by both individuals and institutions. Changes in the components are made infrequently, often as a result of mergers, but occasionally to effect a better representation.

Making a Market

When a firm buys and sells securities for its own account, it is said to be market making. Before a firm can make a market in a security, it has to meet certain Financial Industry Regulatory Authority (FINRA) – formerly the National Association of Security Dealers (NASD) – qualifications with regard to its net capital. These qualification safeguards are designed to ensure that a firm has enough ready capital to back up its quotes so that there's no credit risk in the market.The department that decides which securities to buy and sell and for what prices is called the trading department. Each trader in the department is assigned certain securities to trade. For example, one trader may be responsible for trading over-the-counter (OTC) oil http://www.finweb.com/investing/common-stock.html. During the times that the market is open – on a continual basis – these traders decide what prices their firms will pay to buy and stand ready to sell the securities that they trade.The price at which a firm stands ready to buy a security is known as its bid price. The price that the firm stands ready to sell a security is called its offer or ask price. By both buying and selling a given security, a brokerage firm 'makes a market' in that security. As market conditions change throughout the day, the trader raises or lowers the firm's bid and ask prices. By standing ready to buy or sell securities at their posted prices, these traders perform the same function that specialists and competitive market makers do on an exchange floor. Here's a brief example:Suppose a trader at ABC Brokerage Company is responsible for making the market in OTC computer stocks. For one of these companies, XYZ Computers, Inc., the trader is currently making the market as "31.75 by 32". In other words, the firm stands ready to buy XYZ stock at $31.75 and to sell it for $32.05. Notice that the ask price is $0.30 higher than the bid price. This difference, known as the spread, is where the firm makes its profit. By selling the stock for $0.30 more than it was purchased for, the firm makes a profit of thirty cents on every share that it buys and resells. Therefore, if the price stays constant throughout the day and the trader buys 10,000 shares and also sells 10,000 shares, the firm makes a profit of $3,000.Needless to say, this is a highly simplified example. Ideally, however, traders would like to buy and sell the same number of shares each and every day so that they would not have any overnight inventory to be concerned with. But this is rarely, if ever, the case. If traders are getting more buyers than sellers – that is, having more people buy from them than are selling to them – they compensate by raising the bid and asked prices. This has the effect of attracting sellers and discouraging buyers. Conversely, if they're seeing more sellers than buyers, the traders will lower their bid and ask prices – which is designed to produce the opposite result. Maintaining balance is important so that the trader doesn't get caught with a lot of inventory if the market should turn bad.Traders who don't want to speculate with their firm's capital will always attempt to adjust their bid and ask prices so that they're buying and selling approximately the same number of shares at all times. A sharply rising or falling market generally has little effect unless the trader has build up a substantial long or short position in the security. If the firm is willing to settle for a small profit on each transaction, little market risk is actually involved.

Profile of the Successful Investor

Successful investors aren’t necessarily any smarter or better at analyzing financial data than anyone else. They don’t have to have degrees in financial planning or business. Many of the most successful don’t have any college degrees at all. But they do generally have some things in common which make them successful at what they do. Here are four characteristics that you can imitate:Successful investors have a plan for investing, and they stick to it. It’s very easy to be tempted by a tip about a hot stock that’s reported in all the financial magazines and websites. But that isn’t the way that successful investors make money. They look at their goals, time frame and knowledge to devise a plan to suit their own needs. For example, if they’re 45 years old and have twenty years until retirement, they implement a 20-year investment plan. Then they gather as much information as they can and invest in things that they know about and are comfortable with. If they don’t understand a particular type of security, they don’t buy it. They only buy investments that they’ve researched or that someone they trust has recommended, and they don’t listen to the financial media. This is how they stay with their investment plan.Successful investors invest consistently. To succeed year after year, they know that they must keep their money constantly growing. They generally use two methods to do this. First, successful investors buy stocks or stock mutual funds, knowing that stocks are the only security with the long-term power and track record to grow their money year in and year out. Second, they keep adding to their investment principal regularly. When you continue adding to your principal, your financial nest egg is virtually guaranteed to grow. One of the most efficient ways to invest regularly is with a system called dollar cost averaging.Successful investors are patient. It often takes time for a good investment to show its true value. Successful investors understand this, and therefore do not get caught up emotionally with the daily ups and downs of the market. They know that success is a long-term race and as such, patience is essential. They don’t jump in and out of investments in an effort to time the market. They buy investments that are high in value and hold on to them until that value is realized in the market. They don’t expect instant growth, so they aren’t disappointed by temporary setbacks when they come.Successful investors are not emotionally tied to their investment positions. They know that to be successful, they must be unemotional. No matter how promising the investment was when first bought, no matter how they feel about it, they know that selling at the right time is just as crucial as buying. If an investment has consistently lost money, they don’t try to recoup their losses. They know that it’s necessary to cut them and move forward. Likewise, if an investment has made lots of money, successful investors know how to protect their gains. They are aware that nothing goes up forever, and they are able to sell a moneymaker when the time is right.

Risk Management

If you're like most investors, you probably think that you're basically safe if your investment principal is in no danger of being lost. Unfortunately, there are only a few types of investments that guarantee no loss of principal, and with those your earnings are likely to be somewhat meager, only keeping up with inflation -- if you're lucky. In other words, you'll have little to no net gain. It's the oldest rule of investing at work: no risk, no reward.If being in the stock market and possibly losing your money causes you to have sleepless nights, then, to be blunt, you probably shouldn't be in the market. There's certainly no shame in that; the stock market is absolutely not for everyone. It might be best for you to invest in money market instruments. Alternatively, you could arrange your portfolio so that a small percentage of it is in the market, and the rest in fixed-income assets.Your investment strategy should be designed to reflect your own risk tolerance. Risk tolerance is your personal capacity, during the time that you hold your investments, to tolerate unfavorable market conditions without making changes. Put differently, it's a measure of how much you can stand to lose without being tempted to abandon your investment program.Your risk tolerance is one of the most important determinants in setting up your portfolio mix. It's more than simply completing a questionnaire. Examining the motivations of past decisions that you've made in your lifetime can be of great aid in assessing your personality and, consequently, your tolerance level. For example, no one likes the idea of losing money. But if anxiety over possibly doing so could cause you to make unwise decisions, then an aggressive investment portfolio is likely not an appropriate choice for you. One of the biggest mistakes that you could make would be for you to go beyond your level of comfort.Before the year 2000, returns in the stock market were excellent for a number of years. People were enticed into believing that the stock market only went up every year. As a consequence, conservative investors suddenly became very aggressive. Many of them paid an expensive price, with some equity portfolios losing as much as fifty percent of their value between 2000 and 2002 because they weren't diversified enough. Without diversity, there's no limit to the amount that you can lose. In managing risk, therefore, it's usually best to start with less and gradually build to a more aggressive portfolio. As you decide that you can accept more risk it can be added a little at a time.You'll also need to consider the amount of time that you have left before you retire. If you have only a few years remaining and you discover that a large gap exists between the total amount of your assets and the amount that you'll need to live comfortably, then you'll probably have to either greatly increase the amount that you're saving or increase your exposure to risk for higher expected investment returns. If, on the other hand, a long period of time remains before retirement, you can afford to do things more conservatively. But, if you discover that you still have a large gap, you may have to follow more aggressive strategies, such as increasing your percentage of equity investments or increasing your retirement plan contributions. Or you might consider pushing back your retirement date. Remember, however, that you must think not in terms of how much you can make, but how much you're willing to lose. If you need to, be sure to seek the help of a professional advisor.

Stock Market Pros and Cons

When you buy a lottery ticket, you're confident that the maximum amount that you can lose is limited to the price of the ticket. The same logic actually applies to buying stock; the most that can be lost is what you paid for it. While the lottery offers a grand prize, there is no set prize amount when you invest in a stock. So, how high can a stock price rise? Some have been going up for years and are still rising. Stocks, therefore (at least theoretically), have unlimited profit potential. Investing in the stock market has proven to be quite rewarding over time. Although stocks go up and down, sometimes with great volatility, they've generally appreciated for more than sixty years. Stocks have historically returned more than ten percent annually, outpacing inflation.Unfortunately, there's no magic formula for making money in the stock market. Patience, however, has proven to be a key ingredient. Historically, most market declines have not lasted more than five years. For those investors capable of waiting it out, the stock market is comparatively safe. There have been only six losing five-year periods in the last sixty such time frames. Patient investors who hold a well-diversified portfolio of stocks have, for the most part, been rewarded.Of course, it's always a possibility that you could lose everything that you have invested in an individual stock. Even if you don't lose all, substantial losses can, and do, occur. The market does fluctuate, which can be both a good and bad thing. Profits can be made from either an upward move (known as selling long) or a downward move (selling short). An incorrect guess could cost you greatly either way.For investors who buy and hold securities, their maximum potential loss is their entire investment, while their maximum potential gain is limitless (again, theoretically). Short sellers, on the other hand, have completely different risks and rewards. Since the short seller makes his maximum profit from a downward movement in a stock's price, he is hoping that the price falls as far as possible, even to zero (in other words, bankrupt). He can then make a profit equal to the proceeds of the original short sale. Zero is as far as a stock's price can fall, so that's the short seller's maximum profit potential. What the short seller doesn't want is for the stock to go up. This is because he has sold the stock at what he believes is too high a price and hopes to buy it back more cheaply when the price has fallen. Buying it back at a higher price would result in a loss. Since there's no limit to how high a stock could rise, in this situation there would be no limit to the amount that the short seller could lose.Generally speaking, bonds and money market funds tend to be the safest investment vehicles, since their prices usually do not change too erratically. Preferred stocks have slightly more risk, and common stocks are the riskiest of all. The offset is that the high-risk situations usually also offer the highest potential rewards. And while stocks must be considered somewhat risky, it cannot be overlooked that they have outperformed all other financial instruments over the long term.