In the aftermath of the pandemic market – or more recently, the massive successes wrought from the Bitcoin craze and the GameStop short squeeze – you may have considered trying out this whole “trading” thing to maximize your profits. After all, if a Reddit forum can drive a near-obsolete stock to almost $350 overnight, there must be something to be said for leaping in and out of the market as a trader instead of an investor – right?
Well, not exactly. While it’s true that a handful of traders did see astronomical profits off their short-term GameStop holdings – to the $11 billion detriment to hedge fund short sellers – it’s also true that many trades mistimed their investments. Famously, YouTuber David Dobrik invested $50,000 at GameStop’s peak…and then saw over $85,000 float away when the stock crashed.
Statistics on the matter vary widely, depending on the researching institution. Still, it’s widely presumed that the majority of day traders end like Dobrik – at least, eventually. It’s estimated that only 1% of day traders accurately (or luckily) time the market. Furthermore, 10% or less make any sort of long-term profit, while less than 5% eke out a sustainable living.
At the end of the day, day trading is much more like gambling than is investing. And while many famous traders wax poetic about the potential of their craft, it’s better for your long-term goals that you should be an investor – not a trader.
Investing vs Trading: Key Differences
In some respects, trading and investing are quite similar. Both involve putting money into the stock market in the hopes of seeing high returns. Likewise, each takes on some amount of risk to chase said returns.
But ultimately, trading stocks and long-term investing are more dissimilar than alike – at least where it’s important.
What is Investing?
Investing is the practice of putting your money into the stock market – investing it, if you will – to build up wealth over years to decades. The end goal is to craft a well-diversified portfolio that minimizes risk while generating reasonably high returns.
To reach their goals, many investors spread capital across investment vehicles, such as:
- Retirement funds like 401(k)s and IRAs
- Stocks and bonds
- ETFs (exchange traded funds)
- Mutual funds
- Real estate investment trusts
Additionally, many investors define what makes an investment acceptable for their standards. They may seek high diversification, risk-adjusted returns, and a low turnover in their broader portfolio.
On more granular terms, their asset allocation strategy may require a security to generate consistent dividends, have a robust underlying balance sheet with a history of profits, or generate quick returns at comparable risk. Often times, investors will mix and match these strategies to further diversify their holdings and match profits to risk.
And, unlike traders, investors are not wont to flee positions at the first sign of trouble – even if they incur short-term losses. Instead, they ride out downtrends and maybe even buy the dip to capitalize on rebounding prices. As to just how profitable this strategy can be, we give you the 2020 coronavirus pandemic market:
What is Trading?
Trading, on the other hand, involves trying to beat the market and top the returns of buy-and-hold investing. While the S&P 500 is noted for generated 6-10% annual returns on average, traders may seek 10% profits every quarter or even every month, thus compounding their returns.
And whereas investors hold their positions for years to decades, a trader may jump in and out of a position in minutes, hours, or weeks. Instead of going in for the long haul, they try to buy the dip and sell the peak – even if the difference is only a few pennies over the course of an hour. And instead of waiting out downturns, they often employ stop-loss orders to sell positions if they incur losses over a few percent.
By taking advantage of short-term market fluctuations daily or weekly, traders hope to dramatically increase their annual profits compared to investors. As a result, they’re also far less interested in examining the underlying company to see if a position is worth holding in their first place. Instead of looking at a holding’s balance sheet or dividend history, they’re more interested in technical factors like:
- Low share prices
- Industry growth
- Moving averages
And, just once in a while, traders may also capitalize on crazy notions posited in online forums like Reddit. (If they’re lucky, they may even turn a profit – but don’t count on it.)
The Numerous Downsides of Trading
Admittedly, both trading and investing can be risky enterprises, depending on where, when, and how much you invest. And dependent upon your experience and emotional makeup, what’s right for you may not be right for everyone else.
That said, when it comes to your long-term future, the average person should be an investor, not a trader. Timing the market, beating the S&P, and securing gains before a blip in the market undermines your luck-won success is a game best left to professionals (who, even then, aren’t betting with their own money).
That’s not to say that many investors don’t also trade; in fact, many set aside a small portion of their investing funds – usually advised as less than 5% – to play the field. But the small amount of capital allocated to the activity should give you an idea of just how risky even experienced investors view trading.
Boom or Bust
As an investing strategy, trading can either make you rich or wipe out your riches in a matter of minutes. For those investors who bet the bulk of their portfolio on a few stocks or jump in and out of positions in minutes, trading more accurately looks like gambling. And in this framing, it’s best to ask yourself: is it really wise to put the down payment for my house into a slot machine?
If you answer no, then why would you gamble where your short-term losses can actually cost you more than you bet in the first place?
Day trading is not like dabbling in investing. It’s possible for an investor to take a hundred bucks, open a Betterment or similar online brokerage account, and put their capital to work in a handful of managed ETFs.
However, “pattern day traders” have to abide by rules set by the Financial Industry Regulator Authority (FINRA) in order to participate in their craft. Any of these repeat, high-frequency traders who trade on margin must maintain at least $25,000 in their accounts, and if their account drops below that level, they must put in more cash and close their position.
While such margin accounts allow traders to trade up to four times their position, this means that an effective trader must put in a significant portion of money above that $25,000 minimum to cash in on their craft.
Other Costs of Trading
In addition to this high balance minimum, prospective traders will have to open a brokerage or trading account that allows high-frequency trades. They’ll also need software to track their positions and facilitate in-depth, up-to-date research – as well as the free time to spend trading in peak hours.
These costs add up. Not only do most high-frequency traders need significant time away from other employment (if they have it) to do proper research, but brokerage commissions, software subscriptions, and short-term capital gains taxes pile up fast.
And if a trade goes bad in a matter of hours – as we saw with GameStop – then it’s possible to lose more than you invested literally overnight. Unfortunately for traders with high losses, federal law only permits you to write off $3,000 in investing losses per year. While you can carry this balance forward, losing more than $3,000 year over year ultimately puts you in the red.
On the other hand, an investor can choose firms with low (or no) investing costs, and because they usually hold their positions longer, they’re only subject to lower, long-term capital gains taxes. Similarly, because investors build positions over years, they have much more time to do their research and test the field with fewer catastrophic consequences.
Less Time to Recoup Your Losses
Day traders and other high-frequency traders are in and out of positions in less than a day. Or maybe a few weeks. For those who incur losses, that’s not a lot of time for a flagging stock to recover its price. If it ever does.
Contrastingly, an investor who sees portfolio losses, even if they’re substantial now, has much more time to make up losses. Even if they get out of the position that initially dragged their returns down, they have years to decades for their portfolio to generate returns and fill the hole. Traders simply don’t have that kind of time to let their money work.
With Potential for High Reward Comes Inevitable High Risk
As we established above, the shorter your hold time, the higher risk of losing your investment. As such, individuals with a low risk tolerance should avoid trading, which carries much higher risks than investing.
Trading is the ultimate high-risk, high reward financial game. While it’s possible to make fortunes in minutes with luck, it’s more likely that you’ll lose just as much with market volatility.
While short-term trends are hard to predict, historical precedent shows that the stock market always, eventually recovers. But just because the broader market performs doesn’t mean that a particular security will ever rise again.
The Costs of Investing
Of course, investing comes with its own set of risks and downsides, too. For example, just because the market has always performed historically does not mean that it will continue to. Plus, if you’re improperly diversified, you risk losing capital in one section of the market. All while missing out on high returns in other sections.
Additionally, investing requires you to tie your money up in the market for much longer than day trading. This exposes your market to additional long-term risks and requires that you effectively remove the money from your budget’s circulation.
Investors also have to accept that a highly successful trader may generate returns of 10% or more per month. Whereas the average to aim for in investing falls around 10% per year. This makes investing a slower form of earning money. Although traders, by definition, are unable to enjoy the effects of compounded interest.
Investing may also generates a fear of missing out in some. And it’s understandable; who wants to make only 10% per year while some get-lucky trader earns $1 million because they made a good Bitcoin buy? But the chances that any one trader will make the right call and get rich quickly is infinitesimally low. For the average person, you might as well go play the slots and seek your fortunes there.
The Benefits of Investing
Investing does carry unique risks when compared to trading. But when you look at the long-term rewards, the benefits tend to be worth it.
For instance, investing gives you ample opportunity to plan a proper tax strategy. By reducing portfolio turnover and selling when it makes sense, you can lower your tax bill. This means you can benefit from tax-loss harvesting.
Additionally, because you’re managing money on a longer time horizon, you can plan for your future with more certainty. Plus, you can stress-test various investment strategies with your financial plan to pick the right securities for your portfolio.
Investing also comes with the potential to earn more than one type of income, plus other benefits. Aside from selling stocks at their peak to rebuy them when they dip – as some investors did amidst the coronavirus pandemic market crash – you can also take advantage of:
- Compounding prices
- Dividend income
- Bonus issues
- And even shareholder voting rights
Why You Should be an Investor – Not a Trader
At the end of the day, perhaps the most important realization is that most successful traders do so not from the comfort of their living rooms. But in a cubicle at a bank or hedge fund.
Institutional traders don’t risk their own funds, have better backing, and more advantageous information and tools to help them work. For the average day trader, hoping to meet their success is a foolhardy, expensive venture. It comes with much more risk than begets returns.
And in the game of speculation and educated guesses, it’s better to play the long game and maximize your potential. Rather than gamble on a far-fetched whim.