Active Trading Can Ruin Your Investment Returns

This is a guest post from Matt_SF at Steadfast Finances.

(Photo by stevegarfield)

If you’re bored with passive investing and think you’ve got the mojo to become the next George Soros, you might be under the false assumption that all you need is a tricked out multipanel PC, spend sixteen hours a day watching CNBC, and follow the top 20 most popular traders on StockTwits.

Allow me to save you the crushing blow to your ego and half your brokerage account by saying… it ain’t gonna happen!

Truth is, actively buying and selling stocks (e.g. trading) is one of the fastest, yet seemingly innocuous, ways to decimate an investment portfolio if you don’t know what you’re doing.

Trading commissions, getting stopped out time after time, and short term capital gains taxes will quickly eat away at your account balance faster than you will realize. Before you know it, you’ve invested three months of your time, dropped $100s (maybe $1000s) on commissions, and if you’re lucky, your portfolio balance is roughly equivalent to what you would have had you stuck with Plain Jane index funds.

The Real Dope on Active Trading

Forget the idea that you’re going to make major bank being an active trader right out of the gate — if ever.

That idea is pure hype meant to draw you into the game. It’s cleverly scripted advertising meant to convince you to open a brokerage account and experience the adrenaline rush of clicking the BUY button.

Truth is, only a small percentage of active traders can consistently make money over the long haul.

Research has shown that approximately 80% of day traders lose money over a 6 month period. Even worse, only 20% to 35% of professional mutual fund managers — folks that have invested their entire academic and professional lives — can outperform the S&P 500 on an annual basis.

Not exactly the encouraging, pump-you-up statistics you would hear in a discount broker commercial.

To be fair, it is true that there are a chosen few that that can outperform the market. Whether that is due to pure talent, excellent trading discipline, or a 20 year lucky streak, is debatable. The general rule of thumb is that active trading is an evolution based process where the successful traders survive by rapidly adapting to what the market is doing. If you can’t adapt (e.g. trade correctly or not at all), you capital is wiped out and you’re out of the proverbial game.

Hidden Costs of Active Trading

Trading isn’t cheap. In fact, it can be rather expensive even if you’re in the black.

Consider the following expenses:

1. Trade Executions / Broker Commissions. Let’s say your broker has a $9.99 commission per every trade you make. Being an active trader, you probably expect to make a minimum of 10 trades per month. Every trade has a buy and a sell order, so that’s 20 executions, which comes to a minimum expected loss of $200 each month. That’s a minimum annual expense of $2400 just to do business.
2. Trading Programs & Data Streaming Fees. If you’re a big dog, you probably wouldn’t settle for your standard online broker trading platform. You could if you were frugal, but you might try using trading software platforms like QuoteTracker, eSignal, or TradeStation. These will cost anywhere from a few $100 per year, or for the more complex systems with lots of bells and whistles, can cost upwards of several thousand dollars per year. Depending upon your goals, your tools will need to be up to the task.
3. Repeatedly being Stopped Out. A stop loss order is an active trader’s best friend since it creates a predetermined exit point, and helps maintain trading discipline. However, being stopped out also means you were wrong. If you’re wrong, you’re almost always going to lose money. For example, if you buy a stock at $100, and you have a 5% stop loss order, your stock would automatically be sold by your broker if the $95 price level is touched. So you’re out X number of shares times $5 plus commissions. Thus, if you’re making a minimum of 10 trades a month, and you’re wrong half the time, you better hope your remaining 5 trades made more than 5% on average when you sold them.
4. Short Term Capital Gains Taxes. If you make money, the tax man wants hit cut. Unfortunately for traders, short term capital gains taxes (investments bought and sold in less than 1 year) can cost as much as 40% of your profits, so be prepared to take a major hit when taxes are due (assuming you made a profit). Long term capital gains taxes are far less severe, and most people will pay somewhere in the 15% range.
5. You Will Need an Accountant. Unless you have accounting experience or you’re into you’re into self-flagellation, you will probably want to consider hiring an experienced accountant. There are trades to analyze, expenses to itemize, and tons of potential pitfalls that a good CPA will catch that you might otherwise overlook. They aren’t cheap, but a good accountant is worth their weight in gold.

Don’t get me wrong, I’m not trying to scare you or dissuade you from becoming an active trader. I am simply trying to give you a moment of, well… pause.

If the idea of buying a few high profile tech stocks gives you a little adrenaline rush, then have fun and enjoy the ride. Just make sure you realize that you’re not playing with Monopoly Money, and the surge of adrenaline can be fairly addicting.

On the flip side, there is absolutely nothing wrong with buying a few blue chip companies and holding them until the day you die. The old strategy of “Buy & Hold” is far from dead in my humble opinion.

Just know that before you jump into the deep end of the pool, it would serve you well to review your goals and determine if active trading is really for you. It isn’t glamorous, it can be very stressful, and it can get fairly ugly if you continually click BUY and SELL without serious consideration each and every time you do it.

If you’re a fairly conservative person and you still want to give active trading a try, it would probably be in your best interests to practice your skills in a fantasy stock market game. This way, you get the luxury of playing with Monopoly Money and if you lose your ass(ets), you have a reset button. Real life trading doesn’t have such a luxury.

Tagged as: Investing