The Covid-19 pandemic has changed the way Americans live and work, and even how they invest.
With more time on their hands, many individual investors have turned to day trading. Most major online brokers have seen a major uptick in new accounts. But day trading — essentially, the act of buying and selling stocks to make a quick profit — isn't the best way to build wealth, according to Ben Carlson, a CFA and the director of institutional asset management at Ritholtz Wealth Management.
"The slow, boring, 'get rich slowly' path is still probably the right path for the majority of people," says Carlson, who is the author of "A Wealth of Common Sense: Why Simplicity Trumps Complexity in Any Investment Plan." That message is also the theme of his blog and podcast.
As the ups and downs of GameStop and other meme stocks this winter demonstrated, day trading can easily backfire. "People who spend more time messing with their investments, playing and moving around in trading and potentially overtrading, eventually that catches up to you," he says. "It's not a long-term strategy for most people."
Video by Helen Zhao
Here's why being patient and investing passively is more likely to result in long-term wealth.
When it comes to building wealth, just saving isn't enough. When you park your money in a regular bank account, it diminishes in value over time due to inflation.
The most effective way to build wealth is by investing, experts say, as long as you go about it in a strategic and well-advised way.
Before you invest any of your hard-earned cash, though, Carlson suggests asking yourself a few basic questions. For example: "What are you investing for in the first place?" "What is your emotional relationship to your financial goals?" If you're saving for meaningful milestones like retirement, a house, or a wedding, your investment strategy should be thoughtful, he says.
If you're hoping to profit off the stock market, you're far more likely to see strong returns if your keep your money in a diversified portfolio for a longer period of time, he explains. Research supports his claim: Historically, investing in passive funds that track the S&P 500 or in mutual funds yields better long-term results when compared to stock picking.
Video by Stephen Parkhurst
"Trading on a daily basis is a coin flip," says Carlson. "If you look on a daily basis, the stock market is basically a 50-50 proposition between being up or down."
Legendary investors like Berkshire Hathaway CEO Warren Buffett offer the same advice. "In my view, for most people, the best thing to do is to own the S&P 500 index fund," Buffett told his company's shareholders in July.
"Keeping costs to a minimum is enormously important in investing, whether it's farms or buildings in New York. But particularly in stocks," Buffett told CNBC in a 2014 interview.
One of the appeals of online trading in a brokerage account is that there's little or no initial cost involved, which has lowered the barrier to entry. But that's misleading, Carlson explains. "People forget the impact [of trading] on things like their taxes when they move their money around."
Video by Courtney Stith
When you sell an investment and make money, your profit may be taxed, just like other kinds of income. Taxpayers collectively log hundreds of millions of transactions each year involving so-called capital gains and losses, according to IRS statistics.
Day traders who quickly buy and sell stocks are paying short-term capital gains rates, which are the same as your normal income tax rate. To qualify for the preferable long-term capital gains, you have to hold an investment for more than a year.
Even if you're going the "get rich slowly" route, paying attention to fees is still important. One of the reasons Buffett recommends investing in an index fund is because it's a low-cost way to hold a diverse mix of stocks. The average passive fund, like an index fund or an ETF, has an expense ratio of 0.13%, compared with a 0.66% average fee among actively managed funds, according to Morningstar.
Short-term trading has other negative consequences besides a hefty tax burden. It also means you're missing out on the power of compounding interest. By making regular contributions to your investment accounts, and staying put, not only do you earn interest on your money, you earn interest on the interest it's already accrued.
The benefit of compounding interest far outweighs the risks that come with trying to time the market. "If you're trading in and out of stocks and timing the market, it just invites more behavioral mistakes into the equation as opposed to having a more long-term buy and hold strategy, which is granted much more boring," Carlson says.
Video by Jason Armesto
Even if you have the energy and risk appetite to play around with stocks, you're still at a disadvantage, he explains. "Wall Street professionals spend a lot more time and have a lot more firepower and computing power than the average investor."
Your best bet is using time to your advantage, he says. "The further you can lengthen your time horizon, the higher your odds of seeing a successful investment, whereas, as you shorten them, you're playing in a ballgame with pros more often and it's much harder to do that on a consistent basis because the win percentage is not as big."
If being passive feels lazy, try changing your mindset, Carlson says. "If you're doing something with your money and you're making a trade or a transaction, you almost feel like you have your hands on the steering wheel and are in more control of what you're doing. But doing nothing is a decision when it comes to investing, too."
More from Grow: