Trading vs. Buy-and-Hold
The goal of most investors generally is to buy low and sell high. This can result in two quite different approaches to equity investing.
One approach is described as “trading.” Trading involves following the short-term price fluctuations of different stocks closely and then trying to buy low and sell high. Traders usually decide ahead of time the percentage increase they’re looking for before they sell (or decrease before they buy).
While trading has tremendous potential for immediate rewards, it also involves a fair share of risk because a stock may not recover from a downswing within the time frame you’d like—and may in fact drop further in price. In addition, frequent trading can be expensive, since every time you buy and sell, you may pay broker’s fees for the transaction. Also, if you sell a stock that you haven’t held for a year or more, any profits you make are taxed at the same rate as your regular income, not at your lower tax rate for long-term capital gains.
Be aware that trading should not be confused with “day trading,” which is the rapid buying and selling of stock to capitalize on small price changes. Day trading can be extremely risky, especially if you attempt to day trade using borrowed money. Individual investors frequently lose money by trying to use this approach.
A very different investing strategy—called buy-and-hold—involves keeping an investment over an extended period, anticipating that the price will rise over time. While buy-and-hold reduces the money you pay in transaction fees and short-term capital gains taxes, it requires patience and careful decision-making. As a buy-and-hold investor, you generally choose stocks based on a company’s long-term business prospects. Increases in the stock price over years tend to be based less on the volatile nature of the market’s changing demands and more on what’s known as the company’s fundamentals, such as its earnings and sales, the expertise and vision of its management, the fortunes of its industry, and its position in that industry.
Buy-and-hold investors still need to take price fluctuations into account, and they must pay attention to the stock’s ongoing performance. Naturally, the price at which you buy a stock directly affects the potential profits you’ll make from its sale. So it makes sense to buy the stock at a price you believe is reasonable. While you hold the stock, it’s also important to watch for signs that your investment isn’t going the direction you planned—for example, if the company regularly misses its earnings targets, or if developments in the industry turn bleaker.
Sometimes you’ll decide, after reviewing the company’s fundamentals, that it’s worthwhile to ride out a slump in price and wait for a stock to recover. Other times, you may decide you’ll have better returns if you sell your holding and invest elsewhere. Either way, it’s important to stay on top of the stocks you own by paying attention to news that could affect their value.
Advanced Short-Term Trading
There are a number of ways that some experienced investors seek increased returns by taking on more risk.
- Buying on Margin. When you buy stocks on margin, you borrow part of the cost of the investment from your broker, in the hopes of increasing your potential returns. To use this approach, you set up what’s known as a margin account, which typically requires you to deposit cash or qualified investments worth at least $2,000. Then when you invest, you borrow up to half the cost of the stock from your broker and you pay for the rest. In this way, you can buy and sell more stock than you could without borrowing, which is a way to leverage your investment.
If the price goes up and you sell the stock, you pay your broker back, plus interest, and you get to keep the profits. However, if the price drops, you may have to wait to sell the stock at the price you want, and in the meantime, you’re paying interest on the amount you’ve borrowed. If the price drops far enough, your broker will require you to add money or securities to your margin account to bring it up to the required level. The required level is based on the ratio of your cash and qualified investments to the amount you borrowed from your broker in your account. If you can’t add enough money, your broker can sell off the investments in that account to repay what you’ve borrowed, which invariably means that you’ll lose money on the deal. In most cases, the decision to do so resides not with your broker, but with the brokerage firm your broker works for, which often has specific policies regarding margin trading and margin account administration. Read any information regarding margin accounts carefully to understand the firm’s policies and costs as well as risks.
- Short Selling. Short selling is a way to profit from a price drop in a company’s stock. However, it involves more risk than just buying a stock, which is sometimes described as having a long position, or owning the stock long. To sell a stock short, you borrow shares from your broker and sell them at their current market price. If that price falls, as you expect it to, you buy an equal number of shares at a new, lower price to return to your broker. If the price has dropped enough to offset transaction fees and the interest you paid on the borrowed shares, you may pocket a profit. This is a risky strategy, however, because you must still re-buy the shares and return them to your broker. If you must re-buy the shares at a price that’s the same as or higher than the price at which you sold the borrowed shares, after accounting for transaction costs and interest, you will lose money.
Because short selling is in essence the sale of stocks you don’t own, there are strict margin requirements associated with this strategy, and you must set up a margin account to conduct these transactions. The margin money is used as collateral for the short sale, helping to insure that the borrowed shares will be returned to the lender down the road.
