Trading vs. Investing: Which is More Likely to Reap Rewards?
Today’s stock market is heavily populated with young and novice players anxious to take advantage of the opportunities it appears to offer. Many people are reaching for the golden ring, trying to find the best way to bring in the big bucks. This week's question asks me to compare two strategies that represent VERY DIFFERENT money-making approaches to the stock market. NOTE: Since I’m not a credentialed financial advisor, the answers (observations) I give are strictly my opinion.
Q: What are the pros and cons of “buying the dip” versus dollar-cost-average investing?
These are two very different approaches to making money in the stock and bond markets - essentially trading (buying the dip) versus investing (dollar-cost-averaging). Simply stated, investors seek larger returns by employing a patient, long-term approach of “buying and holding” while traders enter and exit the market seeking smaller more frequent profits over shorter periods of time…perhaps daily, monthly, quarterly, etc.
Personally, I’m a buy and hold, dollar-cost-averaging kind of investor, and follow an approach many folks utilize to build their retirement accounts so they are comfortable in their golden years. Some of these investors probably have some fun buying the occasional dip with non-retirement funds, but they most likely choose to take a slow and steady approach and typically ride out routine market instability by keeping their investments in place. This is the opposite of the "buying the dip" approach used by traders who try to "time the market" and attempt to profit from short-term volatility.
The Long Game
Investors aim to gradually build their wealth by holding a highly-diversified portfolio for long periods, enhancing it through stock splits and dollar-cost-averaging by reinvesting capital gains, dividends and interest into additional units. This sets the stage for the amazing power of compounding to work its magic on those long term holdings.
In short, a typical investor buys good quality, highly diversified units, and exercises patience over the long term as opposed to buying a fluctuating market’s dips, attempting to maximize profits in the short term. These folks are much less inclined to track the performance of their portfolios on a short-term basis. Steady growth over time is much more meaningful to them than chasing day-to-day fluctuations
The Short(er) Game
It might be stated that a trader’s pursuit of frequent transactions in a volatile short-term market is an attempt to generate returns that out-perform those of a buy-and-hold investor. You’ve heard the old saying, "Buy low, sell high." A trader’s goal is to do that frequently…or to sell high and to cover at a lower price – a short sell – in a falling market.
Traders usually employ analytical tools to help predict the short-term future and protective stop-loss orders to close out losing positions automatically at predetermined prices. Trading is risky, particularly in the hands of new or inexperienced traders, and generally creates higher taxes on gains. Under current law, short-term gains are taxed at higher rates than long-term gains. Short-term trading also requires greater research and monitoring, and has a higher stress rate due to the nature of the game.
The difference in trading and investing has a great deal to do with time. A buy-and-hold strategy is often favored by investors who don’t have or who don’t wish to spend much time researching the market – except during initial buy-in. Trading involves a fast and easy approach to quick profits and the thrill of market participation versus investing's long term approach, which requires patience but hopefully leads to the satisfaction of watching your retirement package grow through appreciation and compounding.
Patience, Young Investor
In general, investing is based almost entirely on fundamental analysis, which unlike its technical “buying the dip” counterpart, involves less guesswork. An obvious drawback to a buy-and-hold strategy is the associated opportunity cost - tying up assets for long periods. And your patience and resolve will be tested as you avoid the temptation to partake in “dip” opportunities along the way.
Without question, inevitable market corrections lead to prolonged bear markets. This can cause buy-and-hold portfolios to lose large chunks, if not all, of their gains. Under such conditions, steel-willed investors must stay the course, reduce unit costs through dollar-cost-averaging and await the inevitable turnaround.
Buy-and-hold remains one of the most popular and proven ways to invest in the stock market. The practitioners of this strategy do not worry about timing the market and avoid basing their decisions on subjective patterns and analysis. Still, investors must act prudently to guard against impatience with major corrections.