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Individual trading comes with many caveats. Most investors would do better investing in index funds. Sign up for the Ask the Expert e-mail newsletter Question: I do a lot of stock trading online, but then I see my profits eaten away by taxes. What can I do to avoid that? –Yaseen Qureshi, Cincinnati, Ohio Answer: How about not trading so frequently? I’m not being flippant. I’m totally serious. Aside from the fact that high tax rates on short-term gains can seriously undermine your performance, there’s also a body of research that suggests that more active investors generally fare worse than those who are more restrained - and those who trade the most tend to do the worst of all. One reason for this “the more you trade, the farther you fall behind” syndrome is overconfidence. Investors who trade tend to overestimate the value of the information they have, with the result that the stocks they buy as replacements often fare worse than the stocks they sold. Then there are transaction costs, which drag down returns. True, online trading has dramatically lowered the cost of brokerage commissions. Even so, brokerage fees haven’t completely disappeared, plus investors also incur other transaction costs, such as the bid-ask spread, essentially a mark-up brokerage firms charge in additional commissions. These costs act as a significant drag on performance over time. And although I’m sure that you and many other traders probably consider yourselves savvy stock pickers able to sift through the thousands of choices out there to find the best buys, research shows that investors don’t usually cast a very wide net. Instead, they tend to buy the stocks that are often in the news. Not surprisingly, these attention-getting stocks are the ones that have been most scrutinized and whose prices are most likely to reflect their actual value, thus offering the least potential for outsize returns. Add up all these factors - the overconfidence, the trading costs, the narrow focus - and it’s already difficult for investors to outperform passive indexes like the Standard & Poor’s 500 or the Russell 2000, benchmarks for large and small stocks respectively. Throw in the effect of taxes on short-term trading - profits on sales of stocks held a year or less are taxed at rates as high as 35% versus a max of 15% for those held longer than a year - and you’ve got an even higher hurdle to overcome. University of California-Berkeley finance professor Terrance Odean has written extensively about the performance of individual investors. If you’re so inclined, you can read about the deleterious effects of rapid trading and taxes at his web site. But I find that many people are unmoved by such research, perhaps because they believe that they’re the exception to the rule. So here’s another suggestion: if you aren’t already doing so, keep records of all your trades and calculate your profits and losses after all costs. By looking at how your trades fared over the same time period compared to the return of a relevant index, such as the S&P 500 for large stocks or the Russell 2000 for small shares, you can get a pretty decent sense of whether you’re adding any value after accounting for costs (except, of course, the cost of your own time). It’s more difficult to calculate the return of your portfolio overall - particularly if you’re adding new money or withdrawing funds over time - but you can do it by using a financial calculator or by consulting investment performance web sites. If after keeping track of your portfolio over several years you find that you can consistently beat the indexes, congrats. Maybe you’re one of those rare individuals who possess the insights and skill to beat the market on an ongoing basis. But if you find that’s not the case - or you’re not willing to track your performance carefully enough to understand how you’re really doing - then you might want to consider abandoning the trading game and simply investing in broad-based index funds or ETFs. You’ll get a diversified portfolio with low cost, plus a shot at higher after-tax gains, since index funds and ETFs tend to generate taxable distributions less frequently than other funds. One final note: if you insist on continuing to trade, you may at least want to confine your buying and selling as much as possible to tax-deferred accounts like a 401(k) or IRA. Doing that won’t help the basic issue of poor performance associated with trading, but at least you can postpone taxes on any gains you do manage to generate until you eventually make withdrawals from your account. Got a question? Ask the expert.
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Posted by kp 9:23 am 21 Comments
 | Add a comment Traders are basically conned into thinking they can consistently outperform the market. Online brokerages such as E-Trade,TD Direct, Schwab want rapid turnover to generate commissions. Media such as CNBC, Fox Business, Bloomberg TV spew endless stories and show floor traders showing that there is action and excitement in the business. Print media like Money, Forbes, BW, Fortune and other exist to satisfy the need for information. WSJ and Barrons have exhaustive reporting to show the facts. Basically there is a huge industry out there to try to convince saps they can beat the market. It can’t be done on a consistent basis as proven by all studies. So why do it? Posted By David, CT : April 13, 2008 2:57 pm
Tax money is not lost. It is the cost for government to provide all the services that the majority of Americans have asked for, Social Security, Medicare, a Social Safety net, roads, education, etc. There is a cost for these things and it should be current taxes. The tax rate should be higher so we are not forced to borrow from our children to pay for the services required by taxpayers today. Pay your fair share! Posted By Tim, Marietta, GA : April 12, 2008 8:32 pm
As I trader, I have to laugh a little because all the long term investors who care about what I do short term. If you made a wise investment, it will grow in the long term. Why are you worried about short term fluctuations. Short term traders can provide liquidity to the market. Traders only oscillate the equity, not drive it. Posted By jon, SA TX : April 11, 2008 6:48 pm
Aaron asked: If mutual funds are the secret to investing how do you explain that not a single dollar of Warren Buffet’s has ever touched one? Simple: Warren Buffett has enough money that he doesn’t need to pay someone else to diversify his holdings for him, which is what you’re doing when you buy a mutual fund. I personally don’t have enough money to buy even just one share in all of the things I’m diversified into via mutual funds, so I’m willing to let the fund operator take his less-than-1% vig to solve that problem for me. Plus, look at Berkshire-Hathaway stock some day. It ain’t called a mutual fund, but given that it’s a piece of all the various and diverse things that Berkshire holds, it may as well be… Buffett didn’t get rich on day-trading. Buffett got rich by choosing wise investments, buying them, and then holding onto them until the rest of the market realized they were worth what he thought they were worth. Posted By J.D., Seabrook, MD : April 7, 2008 2:24 pm
I’m encouraged that day trading isn’t particularly profitable for most compared to working for a living. A real economy needs a lot more of the latter and lot less of the former. I am encouraged that the taxes on such practices discourage such games as short-term trades. Posted By Sean Ryan, Portland, OR : April 7, 2008 10:29 am
I have never heard of any the likes of Warren Buffett building wealth with investments meant to turn a profit only once. Playing with “House” money I understand…risking my future on a bet that probably has all the news priced in just doesn’t seem smart. However, making an extra $100 a day on a $1000 investment sounds pretty sweet. Posted By WishIhadthecourage, Orlando, Fl : April 7, 2008 10:25 am
If mutual funds are the secret to investing how do you explain the fact that not a single dollar of Warren Buffet’s has ever touched one? Posted By Aaron, Raleigh, NC : April 7, 2008 9:02 am
First off the bid-ask spread is not profit for the brokerage firm and not charged by your broker, it’s profit for the market maker. Second, you only pay taxes on gains. If you make $5000 but some of that profit gets taken away from taxes, who cares, it’s still profit! Posted By Mike, Boston, MA : April 7, 2008 7:16 am
Daily trading is gambling. Stupid people lose money to smart people. And there are a lot of stupid people trading daily. Remember, someone’s lost becomes another one’s gain. Posted By Sam, Stratford, CT : April 5, 2008 12:12 pm
Bull, Posted By Orangeburg,sc : April 4, 2008 7:47 pm
Frequent traders are wild speculators, NOT investors. They harm themselves AND the nation. States and localities need money — property & food sales taxes are poor ways to get it. I favor a buy/sell tax of 10% on all stock transactions, with a refund tapering at 1% per year to zero for stocks held ten years. What is more, what I would really like to see is stock prices posted only every 90 days. That is of little consequence or inconvenience to the ten-year SERIOUS INVESTOR !! Investing is a priviledge wasted on the trader. Posted By Allen N Wollscheidt, Brunswick, GA 31523 : April 4, 2008 6:46 pm
i pay zero transaction fees 10 times a month by using zecco. i hate to pay fees, so i MAKE SURE i dont do more than 10 moves a month unless it’s an emergency. Posted By chris, reston VA : April 4, 2008 4:38 pm
The Advantage of Real Estate Carefully selected real estate is easy to predict (for a knowledgeable investor) and easy to profit - even in today’s market - just do your homework and pick the top 1% areas of the country, and have it professionally managed. Using leverage, it’s very common to have your investment double in the first 12-18 months, and increase 700% to 900% in a 10-year hold. A $500,000 investment can produce $7,000 to $9,000 per month income for life - indexed for inflation - without ever withdrawing from the principal. In addition, you can depreciate your investments even as they appreciate in value for HUGE tax savings. After your down payment and closing costs, your tenants are purchasing your investment properties for you. You can even do all of this in your IRA if you have a knowledgeable financial advisor. (Many financial advisors have a lot of opinions - but limited or faulty knowledge - about the advantages of real estate). All Real Estate is local. While many areas are going down, a number of areas in the US are experiencing very healthy appreciation without a significant slowdown in the forecast. Our investments are continuing to appreciate. Real Estate values are based on supply and demand caused by a rapidly growing population. A Harvard study showed that 15 million new housing units are needed between 2005 and 2015. Bottom line - a 10-year buy and hold strategy in the right properties in the best markets will almost always outdo almost all other investments. Posted By Bob Sharpe, Arcadia, CA : April 4, 2008 12:30 pm
Stop spending and start saving (Not in bank or money market, maybe Roth IRA). When retail numbers go down govt will dole you some more cash so you can spend more, Save that tooo. Posted By GK, MD : April 4, 2008 12:08 pm
Don’t forget to add the cost of trading into your basis. You only pay taxes on your profit/gains, so i don’t see what the problem is. Posted By Ken, Seattle, WA : April 4, 2008 12:00 pm
I agree and disagree with your statement. I watch my portfolia go then down then back up , I became a trader and pay taxes on profits.At least i get to keep 70 perdent.As far as retirement accounts . Their is a day of when the Gov, will take 40 percent of your 401K Posted By Lexington, Ky : April 4, 2008 9:20 am
Taxes are one thing, but you forgot to mention the fees associating with trading stocks. That eats into people’s profits also. Posted By Harley Ryder, Galesburg, IL : April 4, 2008 8:34 am
Day Traders want to get rich quick. You might get lucky on a few trades, but your luck will run out. After you lose 10k or 20k you may realize that you are just as ignorant as everyone else. Get rich quick schemes don’t work. Invest early and often in index mutual funds and you will have the best shot at accumulating sizeable assests over your career. Or, keep day trading and wonder where your money went, and blame bad luck. If you want to gamble, buy a lottery ticket. If you want build wealth, invest in a well diversified portfolio of low cost index mutual funds. Luck has nothing to do with buidling wealth. Posted By Millionaire in the Making : April 3, 2008 5:23 pm
In stead of asking people not to trade, did anyone ask why we have such high tax rate to begin with? High tax rate is the fundamental issue in this country. Government overspent on nearly all aspect and billions are “lost” and on one knows where they are. Think about using those hard earn money for the economy or public. I was originally from a very low tax rate region and the government is much more efficient. Just very sad to see all the hardworking individual paying high taxes leading to more debt and not enough money for retirement or even livlihood. Posted By No name, NYC : April 3, 2008 4:01 pm
An opinion, For a smaller individual traders, if you are not capable of making these basic comparisons and computations yourself, you should not be trading stocks. Learn basic math and then start trading. You will be a smarter, and better trader. Money can be made short term, it is not easy and it is not for the stupid. Acutally, I weclome stupid, but might as well mail be your money directly. Posted By david, NY NY : April 3, 2008 3:49 pm
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I made just shy of 680,000 dollars last year dayt rading stocks .
Minus fees, taxes, equipment, feeds, and other expenses, I netted close to 300k.
I don’t have a degree and I worked less than 6 hrs , 4 or 5 days a week.
I take my money and buy stuff.
I nvest in long term strategies and companies.
I own BRK-A and B stock.
My point?
I don’t gamble, I do take risk. Ther IS a difference.
It also kinda sounds like some folks here have lost a bit at day trading.
I DO help the economy buy buying products, eating out, and paying taxes.
My question?
Where else could a high school diploma make $300,000 a year?
-Teague
P.S. I am NOT selling books or tapes, and I have NETTED over 150k for the past 3 years doing this.
You don’t like it, TOO BAD!