Day Trading vs. Investing in Stocks — Which Is Better?

Day trading and investing involve very different audiences, time horizons, trade frequencies, risk profiles, mindsets, tactics, and methodologies. Here we’ll explore the differences and similarities between day trading and investing.

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What Is Day Trading?

Day trading, as the name suggests, refers to attempting to capitalize on intraday changes in the share price of stocks for short-term profits. Depending on how active the trader wants to be, these changes may take place over weeks, days, or hours. Day traders may enter and exit a stock position a few hours apart, for example, to attempt to profit from an earnings announcement or some technical indicator. Swing traders may follow the predicted momentum of a particular stock over a period of a couple weeks.

As such, traders naturally have a higher risk tolerance and a shorter time horizon. Traders try to predict the near-future movement of a stock’s share price by analyzing what are called technical indicators, called technical analysis. In doing so, traders attempt to outperform the market and traditional buy-and-hold investors. Traders may use tools like margin, options, and leveraged ETFs to enhance their exposure, which can magnify both gains and losses. A trader’s style is usually dictated by account size, risk tolerance, and experience.

Trading requires active participation in the market, and thus a dedicated amount of time and effort spent researching companies, stocks, and news.

What Is Investing?

Investing, on the other hand, refers to buying a stock and holding it over a period of years in the hopes of long-term capital growth, building wealth over an extended period to reach a financial objective. Investors hold positions over many years through market downturns, stock splits, and dividend payments to take advantage of the power of compound interest. As such, investors are more concerned with the long-term behavior of a stock, a basket of stocks, and/or the market as a whole, and probably don’t even care about day to day fluctuations in share price.

Since an investor is likely holding for many years, they’re typically making regular deposits to a retirement account like a 401k or IRA from their paychecks, and are not concerned with entry prices. Even income investors are likely simply periodically using dividends or selling shares to generate regular income, while still holding their positions over the long term.

While traders might be checking their account every day or every hour, investors should consciously avoid doing so, in favor of ignoring any short term noise and the subsequent temptation to tweak their portfolio or panic sell their holdings during periods of market turmoil. As such, investing requires a much smaller amount of time and effort than trading, but it also requires patience and the power to resist taking unnecessary, potentially harmful action.

Jack Bogle, founder of Vanguard and considered the father of index investing, famously said that the best thing investors can do is to “do nothing” and “stay the course.” Warren Buffett agrees, stating in a 1996 letter to shareholders:

Inactivity strikes us as intelligent behavior. Neither we nor most business managers would dream of feverishly trading highly profitable subsidiaries because a small move in the Federal Reserve’s discount rate was predicted or because some Wall Street pundit had reversed his views on the market. Why, then, should we behave differently with our minority positions in wonderful businesses?

Investing simply requires choosing an asset allocation and a strategy (hopefully mostly index funds and/or a lazy portfolio) and sticking to it.

Day Trading vs. Investing

It’s largely a case of the tortoise and the hare, the former being trading and the latter being investing. It’s hard to say which one will win. But there are usually slightly different goals in the first place.

Traders are concerned with short-term profits over hours, days, or weeks, whereas investors are looking for long-term capital appreciation over years or decades. The former may be the trader’s full-time job and only source of income, whereas the average investor is more likely saving for retirement 20+ years into the future.

Trading requires constant monitoring and analysis of companies and stocks, and betting on near-future movements, whether up or down. Investing simply requires some up-front work in figuring out what asset allocation and in what long-term securities your portfolio should be. Investors are relying on the assumption that the market tends to go up over time. An investor is typically not going to be holding a short position, where profit is generated from downward stock movement, like a trader would. That is, traders can be bullish and bearish at different times with different positions, depending on their strategy. Investors, by definition, are solely bullish.

Traders are more concerned with technical indicators, charting, short-term mispricings, and earnings calls, usually disregarding the big picture of a company or stock. Trading is likened to gambling in that sense. Investors are concerned with that big picture, betting on what a stock or the market will do over the long term. In that sense, investors picking individual stocks are thinking about the long-term viability and profitability of a company, both of which may be inconsequential to a trader.

Both approaches require a plan. The trader will likely have rigid parameters for their technical analysis (or a backtested algorithm) that inform when to enter and exit positions. The investor will decide on an asset allocation and specific stocks or index funds to hold over the long term. In both cases, it’s likely wise to stick to the plan and not let emotions take over. Both traders and investors are susceptible to ditching their plan in periods of market turmoil when nothing seems certain.

The trader will typically incur a larger tax burden, as short-term capital gains taxes are higher than long-term rates. Moreover, if your broker happens to charge trade commissions, your trading costs will increase greatly. Trading also typically requires a large amount of capital (or leveraged exposure) to generate a decent income, as windows of opportunity — in terms of price differences — are usually very small.

Note that trading is extremely difficult. Successful traders are rare. Traders have to be right twice — once on the entry and once on the exit — for every position. Trading typically inherently requires years of knowledge and experience to be even semi-consistently successful with it.

Long-term investing requires patience. Investors are unlikely to see major swings over the course of days or weeks, except in the case of market crashes, in which case investors are assuming the market will recover. Trying to time the market and panic selling based on emotions while investing are usually more harmful than helpful, so investors should try to avoid tinkering with their portfolio, ignoring any short term noise that is unlikely to affect the long-term outcome. Simply invest early and often.

Investing — Stock Picking or Index Funds?

Within the realm of investing, there’s a sliding scale of active management. On one end, investors pick a handful of individual stocks they believe will perform well over the long term, and these holdings may even change every few years. On the other end, investors simply “buy the whole haystack,” as Jack Bogle said, via a total market index fund to guarantee market returns, holding it over the long term.

Stock picking is somewhere in between index investing and trading. A stock picker may employ fundamental analysis, looking at things like a company’s cash flow and projected growth rate, as well as qualitative analysis on factors like a company’s management style and industry opportunity, to attempt to identify stocks that they deem to be undervalued by the market. This is known as Value investing. Alternatively, an investor may look at metrics like Earnings Per Share (EPS) and Price to Earnings Ratio (P/E) to attempt to identify companies they believe will grow in the future. This is known as Growth investing.

The degree to which one picks individual stocks in their portfolio, like most things with investing, depends on time horizon and risk tolerance. But consider these facts:

• Market timing is usually more harmful than helpful.
• Blindfolded monkeys throwing darts at stock picks consistently outperform hedge fund managers.
• Most stock pickers and active managers underperform the market.
• Value has beaten Growth historically, while Growth has crushed Value over the last decade; it’s likely wise to hold both at their market weights.
• Most stocks lag the market. A small handful drive massive returns.
• On the 50th birthday of the S&P 500, only 86 of the original 500 companies remained.
• Sector bets are just stock picking lite.
• Index funds are self-cleansing in that growing companies rise within the fund and bad companies drop off.
• Similarly, you get exposure to the success of any sector and any stock at any given time in a market index fund, while altogether eliminating sector risk and single company risk.
• Different assets, styles, and cap sizes have performed differently over time. Diversification seems to be the only free lunch.

After nearly a decade of spinning my own wheels trading and stock picking, I finally fully converted to index investing after gradually learning these facts over that time period.

In short, I’m of the mind that even applying a modest amount of leverage to a broad index is statistically a better bet than stock picking, and may even allow you to beat the market.

That said, I recognize that the itch to pick stocks can be strong. I think a sensible idea to satisfy that itch is to set aside a small allocation of one’s portfolio (say, 5%) and go wild with picking stocks, while indexing with the other 95%.

A broker like M1 Finance makes this easier than other brokers. With their intuitive pie visualization, investors can set target allocations such as these and have new deposits automatically directed to maintain those allocations without having to lift a finger. This is known as automatic rebalancing, which eliminates the need for manual rebalancing and the taxes it would incur. Moreover, fractional shares allow even small amounts of capital to be spread across the entire portfolio, allowing every penny to go to work for you. At the time of writing, a single share of Amazon stock is north of $3,000. With $100, M1 users can buy 1/30 of a single share of Amazon, for example.

M1 was designed and built for long-term investors (even engaged ones), not traders. They have a single trading window per day (or 2 for premium users), thereby preventing the aforementioned emotional pitfalls of tinkering and panic selling by removing the temptation. I believe this actually helps investors over the long term, forcing them to stay more disciplined in their approach.

They have an integrable interest-bearing checking account and extremely low margin rates to take advantage of the use of leverage. Another recent new feature is called Smart Transfers, allowing users to set up automatic transfers between accounts based on dollar amount thresholds. I wrote a comprehensive review of the broker here.

Disclaimer: While I love diving into investing-related data and playing around with backtests, I am in no way a certified expert. I have no formal financial education. I am not a financial advisor, portfolio manager, or accountant. This is not financial advice, investing advice, or tax advice. The information on this website is for informational and recreational purposes only. Investment products discussed (ETFs, mutual funds, etc.) are for illustrative purposes only. It is not a recommendation to buy, sell, or otherwise transact in any of the products mentioned. Do your own due diligence. Past performance does not guarantee future returns. Read my lengthier disclaimer here.

Originally published here at https://www.optimizedportfolio.com on January 30, 2021.