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Long Term vs Short Term Investing: The Risks of Short Term Trading

By on March 15, 2021
Categories: INVESTING

A flurry of media coverage on short term stocks has led to an increased interest in short term trading. Unfortunately, investing in trendy, short term picks is a dangerous game of timing the market that is unlikely to end well. When comparing long term vs short term investments, it’s important to understand how each strategy can be used to reach your financial goals. Short term trading may seem to offer the potential of a quick win, but the risk of damaging your long term financial success is high.

Find out how short term trading works, it’s potential dangers for your financial goals, and how long term investing with the help of certified financial advisors may be better suited for growing your wealth.

What are Short Term Investments?

Online trading platforms have made it easier than ever for individual investors to build portfolios with hand-picked stocks and other investments. While diversity is key to any financial planning strategy, focusing on stock fads can lead to major financial losses. Retail investors who recently bought into turbulent stocks hyped on social media and through opportunistic trading discussion forums experienced firsthand the pitfalls of short term trading. While the allure of quick profits and fear of missing out make short term investing an appealing proposition, most investors don’t have the presence of mind and discipline to avoid catastrophic losses.

There are several types of short term investment strategies, but one common thread among them all is the risks associated with each. Here are some of the most common ones to be aware of.

Day Trading

Day trading  is a short term speculative strategy in which investors buy and sell individual stocks throughout the day. The goal is to make quick profits and close out all positions before the market close each day. This strategy takes a large amount of effort and can quickly lead to major losses if not paying close attention to the stocks.

Margin Trading

Many short and long term traders seek to leverage their portfolio by borrowing money and pledging existing securities in their portfolio to trade on margin. Essentially, it involves borrowing money to cover more purchases. While traditional stock trading comes with the risk of losing what you’ve put in, margin trading opens the door to losing even more than what you’ve invested. You’re required to meet the brokerage’s margin requirements, which can change at any time. When your account dips below the minimum requirements, a margin call occurs. That means you’ll need to deposit even more funds into the account in order to maintain the minimum. This type of short term trading is difficult to manage and can lead to losses beyond your initial investment. For example, a loss of 50 percent or more from stocks bought on margin will result in a loss of 100 percent or more, plus interest, and commissions.

Option Trading

Option trading is another type of short term speculative investment used to either hedge or speculate. Option trading volume has increased 50%  since the start of the pandemic in 2020. An option is a financial contract giving the buyer the ability to buy or sell a stock when it hits a certain price for a limited period of time. The investors goal is to profit by speculating correctly or hedging bets without selling existing positions in a portfolio. Options must be exercised or sold by a specified date. There are different types, including call options and put options. Both buyers and sellers carry a significant amount of risk . There’s the potential for market volatility leading up to the expiration date, which could impact the price of the stock and cause the option to lose its value. According to the CBOE roughly 30-35% of all options expire worthless.

Short Sale Trading

Short sale trading is another loan-based type of short term trading that involves selling  stocks you don’t own in anticipation of the stock going down in value and repurchasing it at a lower price. The investor’s goal is to choose stocks that they expect to drop in value, then buy it at the lower price in order to make a profit. But if the stock price increases, the seller will be forced to  buy back the stock, covering their short which could result in a total financial loss. .

The Risks of Short Term Stock Trading

Each type of short term investment comes with its own unique set of risks, but there are also plenty of general risks that come with all of these strategies.

Lack of Goals

Your portfolio can be built and managed to meet both short and long time horizons. However, there has to be a goal attached to that strategy in order to make sound financial choices. Short term trading focuses on quick wins (or more likely, quick losses). But as an investor, it’s important to think of the purpose of your wealth. You need a plan on what you’re saving for, whether it’s retirement, leaving a legacy for your heirs, or something else. If you solely focus on short term stock flips, you’ll miss the bigger picture that a long term strategy offers.

Giving into Financial Mania

The rise of internet news and online forums has increased the potential for financial mania,  as we saw with the recent rise and fall of certain company stocks. As you read these stories of soaring stock prices, it may be tempting to give in and buy stocks. But, as a recent SEC report revealsopens PDF file , this type of mania is unfortunately often followed by panic, in which investors lose a lot of money. A closely linked risk is known as noise trading, which is when investors use news stories and anecdotes to inform their investment decisions, rather than actual data.

Emotional Investing

Even the most seasoned investors can let emotions lead their investment decisions when short term trading — especially when there’s fear involved. Letting your emotions control your portfolio is likely to harm your returns over time.

Lack of Diversification

Short term trading adds a huge amount of volatility to your portfolio. While there may be a place for short term allocations to help you achieve impending financial goals, they should only represent a portion of your portfolio.  Diversification is the key to investment growth. Your assets should be balanced based on your goals.

Impact of Taxes

The gains from short term investing have one last pitfall – taxes. If you are skilled (or lucky enough) to trade stocks successfully using any short term strategy you will likely have to pay short-term capital gains rates which are the same of ordinary tax rates and which can be up to 37% under today’s tax rates. Gains from your short term trading may also increase your adjusted gross income (AGI) limiting your ability to qualify for certain itemized deductions and tax credits with income limits. As with any tax matter, its best to check in with your tax professional to fully understand the impact of your short term trading strategy.

Benefits of Long Term Investing

The alternative to a volatile short term investment strategy is goal-based long term trading. Building your portfolio for lasting long term gain is the best way to mitigate risk and grow your wealth over time. Plus, you’ll enjoy these additional benefits.

Achieve Financial Goals with Multiple Time Horizons

Life isn’t about meeting a specific account balance on a certain date. Your investment portfolio should help you prepare for all sorts of life events, like buying a second home or maintaining your lifestyle in retirement. Having a strong portfolio also helps you prepare for unexpected events, like the death of a spouse or a divorce. Along with an experienced financial advisor, you should craft your portfolio to reflect the need for potential cash flow at different points in time. This differs greatly from the dramatic swings of a portfolio that’s strictly made for short term trading.

Minimize Costs

A long term investment strategy helps to minimize trading costs. Over years of investing, this can avoid stunting your portfolio’s growth because of various fees. The more you trade, the more you’ll pay in commissions. Your portfolio should consider the combined costs of commissions, trading fees, and trading spreads, as well as expense ratios and advisor fees. All of these impact your bottom line and can be minimized with a thoughtful strategy.

Strategize Taxes

Looking at your investment strategy with a long term lens allows you to choose the best accounts to reduce your taxes, both today and in the future. You’ll likely have a combination of 401ks, traditional and/or Roth IRAs, and taxable brokerage accounts. The idea is to fund each of these investment opportunities to maximize those tax savings and balance your holdings appropriately.

Rebalance Using Data

Long term investing also helps you make informed decisions with an evidence-based approach. The price of short term stocks can rise and fall fast, making it impossible to accurately predict when to buy or sell. Using long term data allows for better precision in seeing returns. With the help of your financial advisor, you can evaluate historical data for stocks and indices, alongside economic indicators, to create a smart investment strategy. Plus, ongoing monitoring allows your advisor to rebalance as necessary to maintain the proper asset allocation without dramatic daily trades risking your earnings.

Bottom Line

Short term investing is a high-risk strategy that requires both precision and luck in order to execute successfully. Rather than endangering your wealth by investing in short term trades with a large risk premium, focus on a long term strategy instead. The process allows you to focus on goals that add value to your life, using evidence-based approaches that give you a diversified portfolio.

Need help creating your investment strategy? Contact Dowling and Yahnke Wealth Advisors to assess your risk tolerance and get started with your own financial planning team.

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