It's addictive. It will decimate your bank account. It becomes a daily habit that starts in the morning and continues all day. No, it's not drugs. It's not gambling, either--at least in the technical sense.
It's day trading. And now it's starting to creep into retirement planning.
The Lure of the Stock Ticker
Day trading, or any of its close cousins like "market timing," "playing the market" and "swing trading," involve buying a stock when it's low, and selling it a few minutes, hours or days later at a higher price.
Sounds fabulous on the surface: Just three clicks of a button, and you could net yourself a handsome profit, like the the two Silicon Valley dudes profiled in a 2010 New York Times article who claim to rake in $100,000 to $120,000 a year just from sitting at a café and making trades.
Proponents say a fast internet connection and sophisticated consumer software levels the playing field. And all it takes to beat the market is some baseline intelligence and one eye always on the latest developments. Now, Time Moneyland reports that many people are trying to use day trading as a way to plump up their retirement accounts.
Our reaction to that? "No, no, NO!"
Today we'll explain why we advocate this position so strongly. In our opinion, you're better off trying to beat the house in Vegas than attempting to make money playing the market--at least the former gives you a night of fun.
The Costs of Trading Are More Than You'll Make
Even if you use a super discount broker, you have to pay a small fee on every trade. And when you're trading often, that adds up. Imagine an ice cream store trumpeting that it sold $10,000 of ice cream, but failing to take into account that the ice cream, cones and wages of the scoopers cost $11,000.
Adding insult to injury, the government wants to encourage long-term investment in businesses instead of speculation, so the tax code tries to incentivize hanging on to investments for the long-term rather than constantly trading. If you buy and hold an investment for more than a year before selling it, that qualifies as a long-term capital gain, and the tax is no more than 15%. But if you quickly turn around your investment, the tax on your profit could be as high as 50%!
80% of Day Traders Fail to Make a Net Profit
If you day trade, the odds of actually succeeding are against you. A 2004 study of Taiwanese traders--who use the same strategies as American traders--found that 80% fail to make a net profit in a year's worth of trading. According to the researchers, while many appeared to make a gross profit (like buying a stock for $10 and selling it for $11) the transaction costs ate away at their profits.
In another study, 64% of professional day traders--people who are paid to day trade others' money--ended up with a net loss. One trader did make $372,622, but another lost $279,776.
Would you take a job where you had a 64% chance of losing money? Neither would we.
Someone Always Loses, and It Will Probably Be You
In stock markets, when someone makes a profit, someone else makes a loss. It's a zero sum game. That's because every time you sell, someone is buying, and every time you're buying, someone else just sold. Even when the whole market is on an upswing, someone is paying too much for those ever-rising investments while someone is making a profit from that. When the market is going down, someone is losing money by selling investments while someone else is getting them for a bargain.
Now consider that you are pitting your individual smarts and laptop computer against an army of highly paid Wall Street professionals who have top-of-the-line equipment, minions who do mounds of research for them and expensive proprietary software. The result is that you have only a 1 in 100 chance of making a profit on a consistent basis in day trading.
What About Stock-Picking?
We already know that women make better investors, so it's not surprising to find out that day trading is populated mainly by men who get off on the adrenaline rush of throwing their money on quick bets.
But even regular stock-picking--choosing individual stocks for your portfolio rather than investing in mutual funds or ETFs--has some serious drawbacks. Stock-picking is when you buy individual stocks you think will perform well, based either on in-depth research or just a gut feeling. ("If I had just bought Apple ten years ago ...")
For the vast majority of investors, buying index funds is the best tactic. Even one of the most renowned stock pickers ever, Warren Buffet, says the best strategy for most people is to buy index funds. Index funds track the broader market (for example, one fund might copy all the investments in the S&P 500, so you're basically "investing in the market"). In order to make stock-picking worth your time and effort, you'd have to make awesome picks that perform better than the market as a whole.
And that's really hard: Over a five-year period ending in December 2008, the S&P 500 performed better than 72% of actively managed mutual funds, which work hard to "beat the market." If the vast majority of professionals, with all the resources at their disposal, can't perform better than the market, what are the odds you can?
Not to mention, building your portfolio on individual stocks is a lot riskier than simply investing in an index fund. Let's say you chose a portfolio of five amazing stocks that perform incredibly well. That's great. But now let's say one of those companies tanks. You could've lost 20% or more of your portfolio, right there. Meanwhile, indexes are generally composed of hundreds or even thousands of stocks, so one company's failure would have a much less cataclysmic effect on you.
What to Do Instead
So we'll say it one more time: If you want to invest wisely, choose a diversified set of index funds and then sit on them for a long time. Why? Because:
- Investments are volatile in the short term (and even more so lately), and not in any predictable way, despite claims to the contrary. But history has shown that the broader market grows at the rate of about 7%, so odds are that as long as you invest in a diverse portfolio, your investments will grow over the long term, too.
- Index funds are inherently diversified for lower risk and don't come with the high management fees of mutual funds. They're high value, low cost investments.
- By sitting on your investments, you pay less in taxes and transaction costs.
Ready to get started on your long-term plan? Learn more about the basics of investing with our Investing 101 guide.