As everyone with a computer knows, the web is shoulder-deep in brokerages, services, and publications that promise to help you invest just like the pros. That’s no surprise. It’s a logical step in the democratization of information. On a technological landscape where anybody can become a self-made journalist, filmmaker, or detective, what’s stopping anyone from becoming an armchair investment whiz? The availability of bargain-basement commissions on trades, broad access to research, and specialized trading platforms make it seem like Wall Street’s advantage over the individual investor has never been more negligible.
The only problem is, all those bells and whistles can obscure the fact that there’s still a big difference between what professional traders can do and what individual investors can—and should be doing.
Many of us are do-it-yourselfers by nature and find it rewarding to build our own investment portfolios. The key is to be mindful of the following caveats:
1. Individual investors have an awful track record with short-term trading.
There is research suggesting that different tactical strategies can improve returns. Nonetheless, the performance history of individual investors clearly demonstrates that the majority of investors would be far better off by avoiding short-term trading and just consistently investing.
2. Your tools are no match for the pros.
The short-term behavior of markets is complex and there are thousands of highly-paid PhD quantitative analysts and MBAs spending all of their time figuring out how to gain an edge. These people have lots of time and limitless computer power at their disposal. The idea that a nifty new charting tool can somehow help you to beat these people is naive.
3. You need to win in the long-term not the short-term.
Professional traders focus on the short-term because they are judged and compensated based on recent performance. Many probably realize that short-term trading has low odds of success, but that is the field in which they compete. Individuals need to perform well in the long-term and don’t need to try to compete for short-term results.
4. Being a savvy consumer doesn’t make you a savvy investor in consumer stocks.
Peter Lynch famously advocated that people should ‘buy what they know.’ If you are an avid Facebook user and you see the growth potential, this might be a good reason to invest. On the other hand, stocks of companies with great products often trade at very high prices relative to earnings.
5. Excessive short-term trading can leave you with a huge tax bill.
As detailed in last week’s blog, selling an investment that you’ve held for less than a year at a profit triggers short term capital gains, and you want to avoid that as much as possible. That’s because short term gains are taxed as ordinary income, while long-term gains are taxed at lower rates. For investors in the highest marginal income tax bracket, taxes on long-term capital gains top out at 20%, but short-term capital gains can reach 39.6%.
6. It’s tough to know the difference between skill and luck.
Almost everyone who lived through the .com bubble that ended in 1999 remembers people who thought that they were market whizzes because they owned tech stocks when the market was rising and went ‘all in’ on the tech boom. The true test of expertise was choosing to get out when market levels reached ridiculous highs. When you keep making winning bets in a rising market, it’s easy to convince yourself that you are a savvy trader.
Individual investors with a DIY approach can achieve superior results. With an up-close-and-personal eye on such issues as risk tolerance, cost, and tax consequences, individual investors may in fact be uniquely positioned to look after their own best interests. The key is in understanding what kind of investing will work best for you. Investing for the long term with a steady, consistent hand is in your best interest. Trying to compete against Wall Street is not.