Please Don't Trade Stocks
Don't Trade Individual Stocks. Potential Savings: A lot. Difficulty Level: Low
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According to the Federal Reserve, 14% of Americans own individual stocks.[1]. Brokerage ads are everywhere, and low-commission (or even free) trading is widely-available, quick, and easier than ever.
And yet...I urge you…please, please, please, do not trade individual stocks. There are many great reasons, but I’ll stick with my top 5 reasons not to trade stocks. Not all may apply to you, but at least a couple do.
You are at a tremendous informational disadvantage
People often forget that every time you buy or sell a stock, someone else is on the other end selling it to you or buying it from you. In all likelihood, that person on the other end is an institutional investor, such as a mutual fund company (Fidelity, T. Rowe Price, etc) or hedge fund.
Institutional investors account for at least 70% of all stock trading.[2] These investors spend all of their time researching investments, reviewing public filings, using expensive proprietary research, and interviewing company management (and yet most of them still underperform index funds). When you buy a stock, do you read the last few years of 10-K’s, 10-Q’s, and 8-K’s? Do you create financial models of the company’s likely performance over time and then determine the fair value of the company? The vast majority of institutional investors are doing these things, and they are probably on the other side of your trade.
This is only one of the many ways the deck is stacked against you.
You are unlikely to have special insights the market doesn’t
If you own individual stocks, look at your portfolio and come up with a 2-3 sentence rationale of why you own it and what you think it is worth. Is there something special or insightful about your thesis? Is it based on data, some unique insight? If your answer for what it’s worth is “more than where it is now”, what makes you think so? Have you created a financial model to justify this valuation?
If your special insights come from just closely following the company or sector in the news, that is not special or unique. Millions of people do this. Again, the people on the other side go much deeper and have access to much more information than you.
We are naturally wired to fool ourselves about our performance
I have never met an individual investor who said they underperform the market. And yet, the average investor underperforms the market by nearly 5% per year![3] We all want to think well of ourselves. The result is that we overestimate our performance. 93% of Americans think they are above-average drivers.
And being smart is no guarantee of accurate self-evaluation. 87% of Stanford MBA students believe they are above the median. Having this kind of overconfidence is critical to our self-esteem, but can cause us to make suboptimal decisions.
So, if you are an individual investor and believe you are beating the market, take a hard look at your returns and see if the numbers line up with reality. Don’t forget taxes!
Bid/ask spreads and other costs will eat into your returns
Every time you buy or sell a stock, you are paying the bid/ask “spread”, or the difference between the highest “bid” price to buy shares and the lowest “ask” price to sell shares.
Most frequently-traded stocks have relatively small spreads (a few cents or less), but added up over many, many trades, this can easily cost you 0.5-1% every year. Also, maybe you receive free commissions (but remember, free commissions usually come at a price), but if you don’t, these add up as well.
Finally, the cash balance you hold at a brokerage is generally “swept” into a deposit account that earns almost no interest, while money market funds held at an account with, say, Vanguard, will generally earn something close to the short-term rate (about 2%). This may not sound like much, but it adds up.
Even if you are outperform the market pre-tax, tax drag will likely make you underperform after taxes
Most investors think about their returns on a pre-tax basis, but trading individual stocks (or other financial assets, like cryptocurrency for example) is notoriously tax-inefficient, because most investors are incurring large amounts of taxable gains, often short-term (1 year or less).[4] One of the benefits of owning passive mutual funds or (especially) index exchange-traded funds (ETFs) is that most have little turnover and yield little in taxable income until sold.
If, even after reading all this, you still think you are outperforming the market, I ask you to take the time to measure your returns over a long period, taking into account the tax hit from your net realized gains, and compare that to a low-cost ETF, like SPY if you invest in large-cap companies, QQQ if you invest in tech stocks, etc.
If you truly have outperformed the market over a long period (let’s say at least 5 years), maybe you really are an excellent investor. Or maybe you’ve just been lucky, or investing in growth companies during one of the best periods for growth investing in history (make sure you are using the right benchmark),[5] or making extremely high-risk bets with a high likelihood of sustaining a massive loss at some point (options are notorious for this). But maybe you really are a great investor! It’s not impossible, just extremely unlikely.
Finally, be honest with yourself. Can you prove (use numbers!) that you are beating the market over a sufficiently long period of time? If not, ask yourself why you are trading stocks. Is it for fun? That’s fine, but be fully aware of the cost of the hobby - effectively, your underperformance relative to the market.[6]
So what’s a person to do? That’s a topic for a future post on this topic. But I’ll give you a clue…it rhymes with Windex.
I hope this has been helpful. If you liked it, please press the “like” button and share it with your friends! Finally, if there are any topics you’re interested in, please send me your requests.
[1] A much larger percentage (52%) own stock directly or indirectly through a mutual fund or retirement account.
[2] I’m including computers and high-frequency traders in here. Estimates range from 70% to well over 90%.
[3] Yes, I’m using the performance of individuals investing in actively-managed mutual funds as a rough proxy for individual investor performance.
[4] Trading in a tax-deferred or tax-exempt account like a 401(k) or IRA is a big exception, but even if that is the case, many of the other reasons not to trade stocks apply.
[5] If you invest in tech stocks, use the Nasdaq. If you invest in smaller companies, use the Russell 2000, etc. If you are making out-of-the-money option bets, use an index but apply a leverage multiple.
[6] Bonus link if you’ve read this far and are interested in more - this is a great post about all of the ways “discount brokerages” make money from individual investors. Did you know that electronic trading firms are so confident that individual investors are not good investors that they will (more or less) pay for the right to trade with you? Pretty crazy.