How to Play the Market in the Short-Term

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Most financial advisers have a standard recommendation for ordinary investors: pick a core group of low-fee mutual funds, add money every month and stick with it for the long term.

How boring! Wouldn’t it be fun to play the markets like the pros, jumping in and out, maybe even trying something exotic like betting on options?

Certainly there's a lot more action and excitement with active trading. And it has become easier and easier with deep discount brokerages and online accounts. Charles Schwab (Stock Quote: SCHW), Fidelity Investments, E*trade (Stock Quote: ETFC) and Ameritrade (Stock Quote: AMTD) are in a price war, all charging less than $10 a trade for stocks. You could bet a few hundred dollars without too much fear of losing all your gains to commissions, as you might have in the old days.

And Schwab and Fidelity now offer commission-free trading on a limited list of exchange-traded funds, allowing small traders to move in and out as often as they like.

What are the pros and cons of active trading?

THE PROS:

Total control. You decide what to buy and when, looking for opportunities to pick up bargains, then selling when you think the peak has been reached or some other investment looks more appealing. Mutual fund investors leave all this fun to the pros. As an active trader, you can base decisions on your assessment of the individual stock, its industry or the entire market – whatever you like. And you can move quickly when the landscape changes.

Concentration. Mutual funds spread risk among dozens of stocks, sometimes hundreds. That assures that some will be up when others are down, reducing volatility. But it also means the big wins are often offset to some extent by the losers. By investing in individual stocks, you can avoid this dampening effect if you’re good enough to pick winners.

Tax efficiency. By controlling the timing of your purchases and, especially, your sales, you can manage your tax bills. You can keep your winners long enough to benefit from the long-term capital gains rate, for example. With mutual funds, the buying and selling decisions are in someone else’s control.

THE CONS:

Defying the law of averages. Many studies have shown that few full-time, professional money managers can beat the overall market year after year. So what makes you think you can? It doesn’t take many missteps to drag your overall returns down to average, or below.

Hard work. If you want to own 10 stocks, you might have to study a couple of hundred to find them, and then you’d have to repeat the chore over and over in order to know when to dump a holding for something better. With the Internet, research is much easier than it was just a few years ago, but most people find corporate filings deadly reading. Do you have time to read a mountain of lengthy prospectuses, annual reports, news accounts and analysts’ recommendations?

Betting against better-armed competitors. Long-term, buy-and-hold, diversified investing is basically a bet on the stock market’s well-established tendency to move up over time. Short-term speculation is more like a competition between you and other traders. Every “bargain” you spot looks like a dog to someone else, and many other traders may be more experienced than you.

Active trading can be exciting, and cheap commissions and online trading has made it easier for investors with modest sums. But that doesn’t mean it’s a good idea. For inexperienced traders, the best strategy is to take it slow, and to bet no more than you can afford to lose.

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