Don’t Fall for Day Trading

Day trading is back in a big way. 

Robinhood, the original free stock trading app, has seen a huge influx of users this year. And I  have a strong feeling most of them are new to investing. From Barrons:

“Free trading app Robinhood has added more than three million accounts in 2020, and now has over 13 million. The median age of its customers is 31. The Covid-19 lockdowns and the plunge in markets in March persuaded millions of new investors to open accounts. Some of the action appears to be from people who would otherwise be gambling or betting on sports—both of which were shut down.”

There are stories of people making (and losing) huge sums of money on options trades all over the web, particularly in communities like Reddit’s Wall Street Bets.

I’m here to caution you against day trading. Back in January I wrote a piece titled Trading Too Much Hurts Returns. And in it, I highlighted a study which showed that investors who trade more often make a lot less money on average.

“We divided investors into five groups based on how actively they were trading. Our prediction was that the more active traders, who are also likely to be the more overconfident traders, would trade too much and end up with lower performance after paying their trading costs. And that’s exactly what we found.

We found that the buy-and-hold investors, after trading costs, were outperforming the most active investors by about six or seven percentage points a year.”

Those results are stunning. The investors who traded the most underperformed by a whopping 6-7% per year.

 

Story Time

Like many investors, I had to learn this lesson the hard way. I tried my hand at day trading for a period around 2005. At the time, I had recently gotten my Series 7 (stockbroker) license. I thought I was ready. 

On my very first trade I made a profit of $1,700. That was the worst thing that could have happened. Because then I was hooked. I continued to trade short-term, sometimes using leverage, for a few more months. 

Over those months I lost around $15,000. I basically wiped out my trading account. It was an expensive lesson. But I’d do it again. It allowed me to learn day trading wouldn’t lead to success when I was still in my twenties. 

Since that time I have focused on long-term investments. And the difference has been profound. I believe buy-and-hold is the only way that most retail investors will make money in stocks over the long-term.

Charlie Munger, co-founder of Berkshire Hathaway, describes why this is the case perfectly when he says, “The big money is not in the buying and the selling, but in the waiting.” 

This is so true. I held the stock investments that really moved my portfolio for 4-15 years first. The power of compounding over many years can be truly incredible. Another huge benefit is that you get to take advantage of long-term capital gains, which are taxed at a much lower rate.

 

Resist The Temptation

Today, the lure of day trading is stronger than ever. Stocks are being driven higher by the Fed. And trades are free on almost every big U.S. brokerage. It’s a dangerous combination.

So if any of you out there have recently started day trading, I urge you to be cautious. Try paper trading first. Or at least set aside a small portion of your overall portfolio (5-10%) and only use that for short-term trades. Let the rest sit in great stocks or index ETFs for the long-term. 

And unless you’re a professional, I strongly recommend avoiding options and leveraged ETFs. They are truly dangerous in an environment like this. For every story you see about someone making huge options gains, there are at least three to four huge losses you didn’t hear about.

 

Swing for the Fences in a Smarter Way

If you’re eager to swing for the fences, consider utilizing a long-term approach by investing in startups. Private startups are illiquid. Once you invest, you’re in it for the long-haul. Buy-and-hold discipline is enforced automatically. There’s no risk of panicking and selling too early. It’s one of the reasons I love early-stage investing. Just be sure to research investments properly before you pull the trigger.