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Why Short Term Trading Is Not Investing

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Why Short Term Trading Is Not Investing

In your hunt for new clients, you find many people who are hooked on short term trading.  They can do it through their Smartphones.  They can trade virtually for free.  It’s fun.  It gives them something to talk about with their friends.  Meanwhile, you are trying to explain why financial planning, asset allocation, professional money management and measuring progress to goals is the route they should take.  It’s a tough sell.  Can you win them over when we’ve been experiencing the longest bull market in history?

Approach #1 – The Five Stock Portfolio

We live in a world of instant gratification.  Buy and hold doesn’t appeal to someone who won’t buy green bananas.  We want action.  When we see a profit, we want to take it.  Yet, when something isn’t working out, our first inclination is to wait it out, rationalizing “we were early.”

Suppose your short term trader buys five stocks.  Four work out immediately, one lags.  They sell the four and hold the fifth.  Next, they buy four new stocks.  Three work out, one lags.  They sell the three.  Now they hold two laggards.  The first laggard is probably even lower now.  They buy three new stocks.  By now, you know the story.  They have two winners, which they sell.  They are now holding three losers.  They buy two more.  One works out.  They now have one winner and four stocks that have suffered.

Mistake they made:  They sold their winners for small profits, while incurring significant losses.

Value advisors bring:  You hold your winners and sell your losers.

Approach #2 – Follow the Evidence

It’s human nature to act on emotion.  Financial news on cable stations doesn’t help.  The Dow doesn’t rise or fall anymore.  It soars and plunges.

The website the thebalance.com (1) reported on the Dalbar study showing 20 year returns for the period ending 12/31/15.  Over that period, the S&P 500 averaged 9.85% a year.  That’s pretty close to the 10% historical rate of return we often quote when talking about equities.

During that same period, the average stock mutual fund investor earned only 5.19% a year.  Why? People buy high.  They assume the good times will last forever.  We may even be in a “New Economy.”  When the market declines, they think “This time it’s different.” They sell.

Mistake they made:  They jump in and out of the market.

Value advisors bring:  Focusing on the long term.  Reminding them of the reasons they bought these investments.  What’s changed?

Approach #3 – Your Silent Partner

Imagine had a dream.  You run a nightclub.  There’s a line at the door every night.  You take in a fortune from cover charges and inflated prices on drinks.  Now imagine there’s a guy who visits every night and demands a third of the profits.  You would think this is a nightmare about organized crime!  You setup the business.  You did the advertising.  You hired the right people.  When the business became successful, these guys in leather jackets explain you owe them 32% of the profits.

Welcome to the world of taxation on short term capital gains.  You do all the work picking good stocks.  You are an excellent day trader.  When the tax year ends, you will owe taxes on your short term gains at your standard tax bracket.  If you are single and have a good job, bringing in about $ 158,000 a year, you are in the 32% marginal tax bracket. Nerdwallet.com does a good job explaining how capital gains taxes work at different levels. (2)

Since profits from transactions held under 12 months are subject to short term gains, this means profits taken after 12 months are subject to taxation at long term capital gains rates.  The same person earning $ 158,000 a year might be paying only 15% in taxes ion their long term gains.  (3)  The government is your silent partner.  The tax levels they set discourage short term trading.

Mistake they make:  Taking all the risk, being successful and giving a big chunk of their profits away.

Value advisors bring:  Encouraging a long term approach or, if they insist on trading, explaining the benefits of trading in a tax deferred environment like a retirement account. 

Related: What Do You Expect From Your Clients in the Relationship?

Approach #4 – It’s a 24/7 World

Years ago, most of the action was on the New York Stock Exchange.  It was open 10:00 AM to 4:00 PM.  Today, trading takes place across all time zones.  Breaking news may affect markets in Asia, having an immediate effect when the markets open in New York.  As an individual investor, you have little or no chance to get your order in first.  You’ve seen gapped openings during volatile markets.

Let’s assume there were only three major world exchanges.  They were London, New York and Tokyo.   Even if you were a professional day trader, you can’t stay awake 24 hours monitoring each market.  Because we are in a global economy, the short term trader is often reacting, not acting.

Mistake they make:  Thinking they can stay on top of markets by frequently checking their smartphone and getting alerts.

Value advisors bring:  A large firm with many analysts worldwide, plus offices in many countries.  They can report back, providing the advisor with the firm’s research on the long view.

Approach #5 – The Percentage Argument

Let’s assume a 10% annualized return in the stock market would be terrific.  Let’s also assume the old saying:  “The market goes up like an escalator and down like an elevator.” Here’s another assumption:  People are reluctant to sell losing stocks.  They often ride them down.

Consider the following:  A short term trader buys a stock at $ 100.00.  It declines by a third to $ 66.00.  To get back to even, that stock needs to rise by 50%.  That’s a tall order.  Even assuming compounding, at a 10% rate of return, it would take about four and a half years to break even.

Mistake they make:  Holding onto losers.

Value advisors bring:  Reevaluating.  Dollar cost averaging.  Diversification.

Short term trading is very attractive.  It’s easy to see why people would conclude: “I don’t need an advisor.”  Here’s another activity where people put up money, hoping for quick returns and don’t need an advisor:  Roulette.  Yes, that’s gambling.

  1. https://www.thebalance.com/why-average-investors-earn-below-average-market-returns-2388519
  2. https://www.nerdwallet.com/blog/taxes/federal-income-tax-brackets/
  3. https://www.nerdwallet.com/blog/taxes/capital-gains-tax-rates/
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