Active Trading: Manage Your Money and Your Time
- Written by Brock Cassidy
Listen Money Matters advocates passive investing. It’s not something that should take over your life. There are hidden costs when active trading.
There is a lot of pressure to buy low and sell high when it comes to investing. When you reach the point where you want to start investing your hard-earned money, you start to hear and read about this more often.
You Don’t Have A Crystal Ball
This leads people to try to predict trends in the market by doing things like delaying investment until after a crash they heard might be coming. The problem with holding cash and waiting is that there is a 100% chance of a loss for the time you hold it. Inflation will rise every day and the cash you hold will not.
The logic of active trading also suggests that people need to constantly reshuffle what stocks they own, or even reconsider whether they want to be invested in stocks, bonds, real estate, or just hold cash.
The entertainment surrounding investing perpetuates this idea; if you watch something like Mad Money with Jim Cramer you will feel a huge push to keep rearranging all your assets.
The problem is that to do well active trading, you have to make two really smart decisions, when to buy and when to sell, a mistake on either end can result in huge losses. Even Warren Buffett only ever buys a company with the idea of holding it for very long time horizons, never with selling it in mind.
By trying to invest in this active way you put yourself in a position where you are trying to out guess the rest of the market participants. Your competition is predominantly made up of major institutions with large teams of Ivy League MBAs who have a lot more information at their disposal.
Even more importantly, most of us generally lack the training and time necessary to focus effectively on evaluating stocks across all factors. We all know that time is our most precious asset. We end up missing a lot of time that we would rather spend on our actual job, hobbies, or with family and friends when investing becomes too active.
It’s The Long Haul That Matters
Fortunately, the U.S. market has always done well over time, so obsession with timing and research don’t have to be aspects of your investment plan. You often hear people in personal finance talk about a 7% annual return.
This theory is derived from the fact that there has been a 6.81% annual return on the S&P 500, the index that most closely tracks the whole U.S. market, between 1915 and 2015 after inflation, if you include dividend reinvestment.
Many people and investment managers roughly calculate long-term return (and encourage themselves to invest) by saying that their investment will double in value every ten years and this assumes a return of just about 7% (7.18%).
Those two factors make it easy to generalize about a 7% return as a middle benchmark for measuring your investment. Most realize that this does not mean that each day has a (7%/365 day=) 0.019% return, so they expect that there is some variability in the market, but many still take actions that eat into their returns. The key thing to remember is that the whole US market has always gone up over time.
All of these rules of thumb and historic trends are only ever supposed to be used as guides. The trend of money doubling every ten years is what has happened in the past if (and only if) the money stays invested in a diversified fund that tracks all of the stocks in the U.S. market.
Many people are uncomfortable making their own choices about investments so they choose to use an investment manager. Unfortunately for those people, the reality is that many investment managers make their commission on trades so are biased toward active trading.
In 2014, 86% of professional investment managers did not hit their benchmarks, often not beating the return of a low-fee fund like Vanguard Total Stock Index (VTI) that simply tracks the whole stock market.
Add to that the fact that clients pay the managers, either per trade, per year, or both, and you end up paying a whole lot to let someone else mess up your investing returns with increased trading.
Biggest Days Of Increase
The trick to making money investing over time is holding on through all of the dips to capture the gain of the overall, upward trend that has always existed in the American stock market.
The foundational thought of all of this is that, overall, publicly traded companies in America will continue to grow faster than inflation and this belief has never disappointed us over a long time horizon. Since the end of the Great Depression there have been thirteen recessions, but the S&P 500 has ultimately still risen 23,751.18% since then, and that’s including inflation!
In the last seven years alone there have been nine days where the stock market (S&P 500) gained over 5%. During that same time, there have been several days of large decline as well, but ultimately the trend to date has been hugely upward.
Almost every time that the market saw a decline of any significance, within a week it came back with a day of big increases. For instance, on October 9th of 2008 there was a decline of 7.62% in the S&P 500, one of the worst days ever in the market. Just a few days later, on October 13th the S&P 500 had its best day ever, showing an 11.58% gain.
Imagine the people who got cold feet between October 9th and October 13th, thought the market would continue to crash (seemingly pretty reasonable!), and so were no longer invested for the biggest day of gains they would have seen in their lives.
That single day had more gain than what is expected over a year and a half using the 7% benchmark! No doubt there were some other bad days in the stock market in 2008, and even since, but since October 9th 2008 the S&P 500 has gone up 131.1% overall (as of August 5, 2015).
Many people are still scared to invest because of what they lost during that period around 2008, but for those able to stick with their investments through that period the rewards have been huge!
The percentage change in the S&P 500 on each trading day from the last ten years is graphed below. When looking at each day it looks as though there is no return being gained, but there was actually a 69.89% return during this time and nine of those ten years have been positive.
You can also check out the outlier days in 2008, there were big down days, but almost as many big gain days to match. The second graph shows the long-term trend by plotting annual return of each year since 1928. Notice that the trendline continues to be very positive over time.
It is very important to push back against the fear of a crash, and remember that when you are investing in stocks you should almost always be investing in the long term, and no matter how things look on a certain day you should trust that gains continue to come over time.
Psychology shows that people have much more fear of losing money than excitement about making money, so it is important to combat that natural thought with reason, history, and statistics.
If you are not investing for the long-term, then you should very carefully assess whether you wouldn’t be better off keeping your money in bonds, CDs, or even savings accounts. If you are investing for retirement or anything else that is more than ten years away you will almost certainly see the best results from the stock market.
However, all your money probably is not being saved for retirement. If your time horizon is shorter you will not want to be invested fully in stocks. For instance, if you are saving for a down payment on a house in three years, you want to consider those other options like CDs and savings accounts so that you can guarantee that you will have the money you need at that time.
No matter what your goals, actively trading stocks on a short time horizon will hugely magnify your risk. As long as you are investing for the long run, just kick your feet up and tune out the news and talking heads knowing your diversified investment will go up over time.
Commission Fees/Early Withdrawal Fees
Whether or not you make the choice to use an investment manager or other professional help with your finances, you still may have a lot of other fees associated with not staying invested for the long haul. So if you aren’t convinced yet to be confident in buying and holding diversified assets, then the other fees you will be dealing with may finally change your mind.
One example of this is the tax on gains of stocks owned for less than a year. I heard someone talking in the Listen, Money Matters Community Forums about how they bought Netflix stock a few months ago, have seen a huge gain, and now are interested in investing elsewhere.
The problem is that this would be considered a “short term” capital gain, because the asset would be sold (for a gain) after holding it for less than a year. This all depends on your income tax bracket, but basically, if you hold the asset (stock, bond, real estate, etc.) for at least a year then you will pay anywhere from 0% to 20% on your gain, instead of the normal 10% to 39.6% you pay on income.
If you don’t hold the asset for at least a year, you will pay your normal marginal income tax rate, just as if you got the money in a paycheck from work. These savings can be huge; a person who normally pays 35% income taxes will end up paying less than half that much (15%) if they hold an asset for more than a year. Check out the chart below to see how much you would stand to lose in your situation if you don’t hold assets for a minimum of a year.
Depending on where and how you invest, you also usually get charged a fee on every trade. Online brokers such as E*TRADE and Scottrade keep that relatively low, say $6-$15 per trade.
However, you have to remember that you will be charged for selling as well as buying. E*TRADE, one of the most popular online brokerages, charges $9.99 for stock trades, and an additional $45 for broker-assisted trades.
The best way to avoid this, again, is simply to buy and hold diversified assets; actively trading individual stocks especially when you are investing smaller amounts, can really punish you. Just remember each time you try to trade a stock on a short time horizon that the trade will cost you $20 between the purchase and sale.
I am currently investing in diversified Vanguard ETFs like VTI, and plan to hold them for a long time (a list of the best Vanguard funds are here). ETFs perform and are purchased like stocks, but are diversified to track either the whole market or a subset of companies in an industry, like alternative energy or biotech. Most online brokerages, including E*TRADE, Fidelity, and Vanguard let you buy ETFs without the gain-killing trade fee.
I made active online trading mistakes myself a bunch of times when I was in college, investing anywhere from $400-$1,500 (large portions of my savings from summer internships or jobs during the semester) into one or two stocks that seemed like they were about to explode upwards.
A few times that stock increase even happened, but just by making the trade to buy and then again to sell within a couple of days or weeks my profits were massively cut and I certainly didn’t gain what I expected.
I’ll break down one example that is pretty close to what actually happened to me: I ultimately paid $500 ($480 + $10 buy fee + $10 sell fee) for a few shares of a stock I thought was going to explode. Luckily in this case it actually ended up going up 5% within a few days making my stock worth $480*1.05=)$504.50.
I then sold it, after checking the stock price, quite happy with my “gain” (5% in a few days sounds better than the supposed 7% a year), only to see that I was left with only $504.50.
Since I wasn’t working full time I didn’t really suffer significant tax losses, but I would have seen that “gain” shrink even more once taxes are considered. Keep in mind this was in a scenario where I actually picked a stock that went up quickly!
The scenario where the investment goes down by the same amount turns out a lot worse; I would have ended up with $456 (an 8.8% loss). The graph below shows what I call the “automatic loss” from buying a stock somewhere like E*TRADE with the intent to quickly sell it – for instance if you pay $100, you will pay $10 to buy and $10 to sell, so fees of $20 right out of the gate leave you with $80 in stock, thus causing a 20% loss without regard to how the stock actually performs.
Seriously, Just Buy And Hold!
It is possible to make gains from purchasing individual stocks and predicting trends, but ultimately it is a lot more difficult and far riskier. You have to have confidence that you know more than the rest of the market participants, which is generally unlikely, and remember that you will have various fees associated with active trading.
For those people that want to outsource any decisions about their finances somewhere else, getting an investment manager may turn out fine, but it is important to realize that simply buying a diversified fund and holding on to it tends to turn out much better over time.
Autopilot Finance: Brock’s site dedicated to automating your finances.
@brockcassidy: Brock’s Twitter address