June 20, 2013

Trading vs. Investing

Credit: rattigon
Last week I ended up waiting in line for a fairly long time while my car’s emissions were tested at a very busy car maintenance facility. I had come straight from work, so I was still dressed up in a suit and tie, and in hindsight, I guess I might have looked a little out of place at a Jiffy Lube. Another customer who had finished reading the same sports section of the newspaper I had, and seemed to be even less interested in the Judge Judy rerun playing in the background than I was, decided to strike up a conversation with me. I’m fairly social and am always up for meeting new people, so it wasn’t too difficult to chitchat until he asked me what I did. When I responded that I was a financial planner and investment advisor, he countered with, “So, you’re a stock trader?” I politely replied, “Of sorts,” but that’s not what I do; that’s not even what I recommend. A harmless conversation with a nice stranger at a Jiffy Lube was not the place to dive into the important differences between trading and investing, but it got me thinking that today’s post just might be!

Trading and investing might be synonymous to some people, but not to me. In my mind, “trading” usually means the frequent buying and selling, or sudden buying and selling, of financially significant quantities of a handful of securities. When I think of the term “investing,” I think of a long-term time horizon, occasional and strategic buying and selling, and a well-diversified portfolio. Before you stop reading and accuse me of splitting hairs, please let me give you three reasons why trading is not investing, and why I believe investing is better
  • Taxes – Let’s say a single lady makes around $75,000 this year. When you look at the 2013 federal tax brackets, she falls in the 25% bracket. This lady is doing pretty well for herself, but she’s doing even better considering that she bought 5,000 shares of Bank of America stock in August of 2012 for $8 a share. She likes “dabbling” in the market from time to time, and she felt she had made a great pick with Bank of America, but now she wants to buy another stock, so she sold the 5,000 Bank of America shares in June of 2013 for $13 a share. Because she held those Bank of America shares for less than a year, her gain must be taxed at her ordinary income tax rate, so her investment will land her roughly $18,750 after federal taxes (((5,000 shares x $13 sales price) – (5,000 shares x $8 purchase price)) x (1 - 25% tax rate)). If she had treated those Bank of America shares as a longer-term investment and sold them in August of 2013 (after she had held the position for a year) for the same $13 a share, the federal long-term capital gain tax rate of 15% would have applied! Her investment could have landed her roughly $21,250 ($2,500 more than $18,750) after federal taxes (((5,000 shares x $13 sales price) – (5,000 shares x $8 purchase price)) x (1 - 15% tax rate)) even though the theoretical sales price was the same! There are certain situations where selling a security with a short-term gain makes plenty of sense, but it’s always worth considering the potential tax benefits of longer-term investing versus the potential tax consequences of shorter-term trading. 
  • Costs/Fees – Whether someone is into stock trading or investing, there are times when new securities need to be bought and old securities need to be sold. In my book, transactions should always have a strategic aim, be executed for tactical, security-specific reasons, or be completed to free up cash, but everyone should remember that transactions are not free. There are costs and fees to facilitate transactions, and depending on your investment custodian and/or investment advisor, these costs and fees could range all over the place. For argument’s sake, let’s consider E*Trade’s fee of $9.99 per trade. If someone were to make 10 trades a year through E*Trade, they would incur around $100 in fees. That might be peanuts to some people, but $100 worth of fees on a $10,000 brokerage account is a loss of 1% of the total account! That means, at best, those fees would dampen the positive performance of someone’s $10,000 brokerage account, and at worst, those fees are just additional salt in the wound of the negative performance of someone’s $10,000 brokerage account. Costs and fees are too insignificant to drive a stock trader or a stock investor’s transaction decisions, but they are significant enough to consider, particularly if the number of transactions is excessive and/or the account’s value is relatively small.
  • Diversification – When I was a senior in high school, there was a statewide contest to see which group of economics students could grow the largest fantasy investment portfolio over a three month period. The rules were that participants could only place trades at the end of the day and could only buy stocks that were trading at more than a dollar, so I quickly convinced my group that the only way we were going to get enough stock price movement to have a chance to win was to go all-in on a single stock that was trading near a dollar that was scheduled to have an earnings announcement in the next couple of days. (PLEASE NOTE I ADVISE AGAINST THIS STRATEGY AND IN NO WAY RECOMMEND IT UNDER ANY CIRCUMSTANCES WHATSOEVER.) As luck would have it, the company whose stock we picked announced that they had beaten earnings expectations and were in talks to be bought out, so the stock soared. The problem was that two other groups of students in the state had done the same thing, and we were all tied in first. My group elected to sell the next day with the hopes that the stock would return to orbit, but the other two groups held on as the stock eked up a few more pennies, thus landing us in third. First place in the state won fame and fortune, and third place won a T-shirt, so we decided to roll the dice again with our all-in, single-stock strategy by buying shares in a company that had an upcoming earnings announcement. This time, the company we picked failed miserably compared to expectations, and some of their executives had decided to leave, so the stock fell like a lead balloon filled with lead balloons. Our strategy had hit us a home run once on the very first try, but as we tried it again and again for the rest of the contest, we lost and lost. We actually finished second to last in the state. I told you that long story because I wanted to share my powerful, first lesson in why diversified investing is better than non-diversified trading - singles and doubles over the long term are a lot better than one home run and a lot of strikeouts in the short term!
If you enjoy trading, that’s wonderful, but call it what it is: a risky hobby. If you’re trying to reach financial independence or if you are trying to maintain financial stability, I urge you to invest, not trade. Trading is sexier, and it may make you feel like you are actually doing something about your holdings more often, but the tax effectiveness, cost effectiveness, and diversification benefits of letting the market do its thing over time are hard to argue with.
Are you a stock picker says he? No. I’m an investment advisor says I!


  1. I am so excited! I know the difference between trading and investing! Keep up the good work!

  2. "...Sir Isaac's talents didn't extend to investing: He lost a bundle in the South Sea Bubble, explaining later, 'I can calculate the movement of the stars, but not the madness of men.' If he had not been traumatized by this loss, Sir Isaac might well have gone on to discover the Fourth Law of Motion: For investors as a whole, returns decrease as motion increases." - From the 2005 Berkshire Hathaway (BRKa) Shareholder Letter

    I like to talk about Buffetts take on Newton's Laws when talking about trading vs. investing

    Hope you are doing well Tom!
    Do you still answer general tax questions?

    1. I am doing just fine. Hope married life is treating you well!

      I'm happy to try and answer any question you may have. Feel free to message me on here or privately if that would be more appropriate.