The current day trading boom will end as these frenzies always do: in tears. While we wait for the inevitable crash, let’s review not only why day traders are doomed but also why most people shouldn’t trade, or even invest in, individual stocks.
Day trading is rapidly buying and selling investments, hoping to profit from small price fluctuations. Brokerages have reported a surge in trading and new accounts this year.
The poster child for this gold rush is Robinhood, a commission-free investing app that uses behavioral nudges to encourage people to trade. Robinhood added over 3 million accounts this year and in June logged more trades than any of the established, publicly traded brokerages.
People can start trading with small amounts of money because Robinhood offers fractional shares. In addition to stocks and mutual funds, the app allows trading in options, cryptocurrencies and gold.
Research has shown that the vast majority of day traders lose money, and only about 1% consistently get better returns than a low-cost index fund. A rising stock market, and a flood of inexperienced and excitable investors willing to bid up stock prices, has convinced more than a few day traders that they’re part of that 1%.
Stocks overall are an excellent way to gain wealth over the long term, if you can weather the downturns.
Extended downturns have popped previous day trading bubbles, including the one that formed during the dot-com boom. The Nasdaq composite stock index rose 400% in five years, only to lose all of those gains from March 2000 to October 2002.
Markets that go down eventually come back up. That’s not true of individual stocks. The sensible way to hedge that risk is diversification. That means buying stocks in many, many companies, including companies of different sizes, in different industries and in different countries. That’s prohibitively expensive for most individual investors, which is why mutual funds and exchange-traded funds are a better bet.
Another way to grow wealth is to minimize investing costs. That means trading less, not more, because trading incurs costs even when there are no commissions involved.
Investments held more than a year benefit from favorable capital gains tax rates, for example. Those held less than a year are taxed as income if the trade wasn’t made in a tax-deferred account such as an IRA. Another way cost is incurred is in what’s known as the bid/ask spread. The banks and financial institutions that facilitate trading in various stocks are called market makers. They offer to sell stocks at a certain price (the ask price) and will purchase at a slightly lower price (the bid price). People who trade stocks instantly lose a little money on each transaction because of this difference. That’s not a big deal for infrequent traders, but the costs add up if you churn stocks in and out of your portfolio.
The biggest potential cost, though, is that every trade exposes your portfolio to the many ways we humans have of screwing up our money. We’re loss-averse and we want to avoid regret, so we hang on to losing stocks. We think that we can predict the future or that it will reflect the recent past, when this year should have taught us that we can’t and it won’t.
We also think we know more than we do, a cognitive bias known as overconfidence. If you’re determined to trade, or day trade, don’t gamble more than you can afford to lose, because you almost certainly will.