Tesla, GameStop, Hertz, Dogecoin: retail traders continue to dominate headlines in the financial news media. Some individuals may be wondering, how is trading different from investing and which is better? For investors saving for long-term goals like retirement, placing speculative bets on single stocks rarely makes sense. But that doesn’t mean actively trading or taking a flyer on a specific company is a bad idea. Just like with everything in life, it comes down to moderation.
Trading vs. long-term investing
Stock picking and actively trading on your accounts is a very different strategy compared to long-term investing. Individual investors who frequently buy and sell stocks may make decisions on based on factors like momentum, brand advocacy, very low share price, perceived industry growth, or as evidenced recently, recommendations in online forums like Reddit.
As an investment strategy, trading is usually boom or bust. For investors betting heavily on a few names or aggressively moving in and out of trades trying to beat the market, trading is more aptly classified as gambling. And that’s not necessarily a bad thing – plenty of people really enjoy playing Blackjack and can win big doing so. But that doesn’t mean you should put your 401(k) or down payment savings in a slot machine.
In a stark contrast to trading, long-term investors generally focus on diversification, risk-adjusted returns, staying fully invested, low turnover, and time-tested investment principles. Traders try to pick the next unicorn or turn a quick profit. Long-term investors usually seek to adopt a formal asset allocation strategy and make few changes.
Diversification is a strategy to help reduce volatility and improve returns on a risk-adjusted basis. During a downturn, a broad-based portfolio generally won’t lose as much as a concentrated allocation could. Long-term investors diversify through different asset classes like stocks and bonds and within an asset class like small and mid-cap U.S. equity.
Long-term investors aren’t trying to hit home runs…or strike out. They’re looking for reliable base hits and runs batted in. Home runs are more exciting, but RBIs win games.
Is trading a good idea? Pros and cons of trading and stock picking
Having an interest in the markets and buying and selling stocks isn’t a bad thing in general. It only poses a risk when individuals risk too much and put their financial position in jeopardy. This is a major downside of trading vs. investing.
Here are some recent examples of how volatile returns from trading and stock picking can be:
Investors who bought GameStop stock on January 27th, 2021 would have lost nearly 55% of their investment by April 21st, 2021. The S&P 500 total return was nearly 12% over this period. If you bought GameStop just one day earlier, you’d actually have a 7% gain, vs. nearly 9% for the S&P 500. And buying the stock on January 1 and selling on January 27th would have produced an incredible 1,740% return vs the S&P which was essentially flat.
Tesla and Hertz
In 2020, Tesla returned over 743% vs. a loss of nearly 92% for beleaguered Hertz while the S&P 500 total return was over 18%. Year to date in 2021 (to April 21st), Tesla’s return is about 5.5% while Hertz is nearly 36%. Once again, the S&P sits in the middle at 11.6%.
Risk vs. return
The examples above are intentionally cherry-picked to illustrate the volatility, risk, and potential rewards for traders. Even if a stock has been producing huge returns, you can’t benefit unless you happen to buy and sell at the right time. Remember, stocks don’t always go up! One of the reasons it’s so hard to find the right time to buy and sell stocks is because there’s no telling how markets will react to changes in capital markets.
Having a ‘play’ account to dabble in stock picking with a full understanding of the risks is perhaps the best way for individual investors to approach trading. In most cases, the trading vs. investing shouldn’t be a binary decision.
Instead, consider a bucketed strategy to invest for long-term needs and wants. To the extent you have the interest and desire to pick stocks, only trade with an amount that won’t materially impact your financials if it fell to zero.
One of the challenges of day trading in a brokerage account are the tax implications. It’s easy to trade stocks with just a couple of clicks, but the tax impact isn’t always as clear. Short-term capital gains are taxed as regular income which can push you into a higher tax bracket and change your eligibility for tax deductions or credits.
Wash sales can be difficult to track at some brokerage firms like Robinhood. Non-traditional investing platforms like SoFi and Robinhood also don’t permit the sale of specific investment lots. This means you can’t isolate shares to realize a loss to offset other gains or minimize a taxable gain.
Pros and cons of long-term investing
It’s a common misconception that individuals need to invest really aggressively to retire early or become financially independent. When it comes to meeting financial goals, reducing volatility really matters. If your account loses 25%, you’ll need a 33% gain just to get back to even. And that assumes the stock comes back at all.
The biggest downside of long-term investing is the fear of missing out (FOMO). If you’re casually picking stocks or reading about the growth of Bitcoin, it’s tempting to think ‘if only I…’. But the reality is that no one has a crystal ball.
Consider what you think would be worse: putting only 5% of your money in a stock that goes on to double or putting 50% of your money in a stock that gets cut in half and never recovers.
Tax planning opportunities
Long-term investing can also offer tax planning opportunities typically unavailable in a stock picking approach. When you’re not trading all the time, you reduce portfolio turnover, which can help lower your tax bill. And when you do need to sell a fund, if you’re working with a financial advisor, they can work to offset the tax impact by picking specific lots or tax-loss harvesting.
Financial planning and projections
Managing money based on longstanding investment principles creates opportunities for financial projections as the range of future outcomes is less opaque. Sudden wealth from picking the right stock or selling stock options after an IPO can drastically change your financial picture, but you have to have a plan for the realistic possibility that it never materializes. This makes planning for the future very difficult.
But most long-term investment strategies use historical data, correlation, and trends to assess how asset classes performed during different market conditions, and likely range of returns and losses. This data makes it possible to stress test a financial plan to make more confident decisions like when you have enough to retire.
When trading or investing, make decisions for your risk tolerance and goals, not someone else’s
It’s easy to get caught up in the markets these days. Every day there’s a headline about a stock soaring or cryptocurrency making millionaires (even if it began as a joke). When deciding how to allocate your money between trading and investing, always keep your value at risk in mind. Ask yourself what you’re hoping to achieve and the impact on your financials if it doesn’t go as planned.
In the financial markets, the only sure thing is that there are no sure things. Unfortunately, the recent gamification of trading makes it much easier for people to forget they have real money on the line.
This article was written by Darrow advisor Kristin McKenna, CFP® and originally appeared on Forbes.
Examples in this article are generic and for illustration purposes only. Past performance is not indicative of future results. This is a general communication for informational and educational purposes only and not to be misinterpreted as personalized advice or a recommendation for any specific investment product, strategy, or financial decision. This material does not contain sufficient information to support an investment decision and it should not be relied upon by you in evaluating the merits of investing in any securities or products. If you have questions about your personal financial situation, consider speaking with a financial advisor.
All indexes are unmanaged and an individual cannot invest directly in an index. Index returns do not include fees or expenses. Past performance is not indicative of future results.