Overview: With the popularity of mobile trading apps like Robinhood, you should understand the fundamental differences between day trading and the life-long skill of investing.
With the advent and popularity of mobile trading apps like Robinhood, investing in the stock market, especially for the young, has never been easier or more accessible.
Commissions are nearly zero, while trading comes packaged with graphic and audio pyrotechnics much like those powering video games. The chance to have some fun and maybe make quick, easy money (at least theoretically) is no further than your fingertips.
Older, wiser market hands don’t recognize quick, brash buying and selling of shares and options as “investing.” Rather, they view attempts to predict from short-term price movements of individual securities and indexes as more akin to gambling.
So-called “day trading” is a slightly different story, encompassing those who make a living buying and selling financial securities, currencies and other instruments over very short periods of time, sometimes minutes. While some day traders claim to be successful, studies suggest that the proportion is quite small since no one but the IRS knows exactly who is making what.
Just as in gambling, the advantage always lies with “the house,” in this case the professional trading class. Wall Street pros have far more experience, knowledge, information and skill than wet-behind-the-ears newbies. Tales – some true! – of instant fortunes made via smartphone or laptop are far outweighed by the disappointments of loss.
Those seasoned in the market know that investing demands discipline, knowledge, skill and patience. All qualities that don’t align with day trading, a form of amateur speculation born in the 1990s when home computers began making connections with electronic trading platforms. Sure, a small number of day traders have managed to earn decent livings from their home offices, but most don’t.
Nevertheless, electronically enabled speculators likely gained an appreciation for an investment world whose basic tenets they also could study and master, with long-term financial security as the goal. Among the many ways to learn, including academic courses and self-study, is the toolbox of instruction provided by BetterInvesting
, which has brought stock market skill and knowledge to more than 5 million people since 1951.
You don’t have to be young to acquire knowledge and to enjoy success in the stock market. But the young do benefit from a specific advantage over older investors: Time. Early follies notwithstanding, the young have more years to learn the ropes and to allow compounding help them amass a solid portfolio and a healthy net worth.
What Is “Compounding?”
In finance, compounding is defined as the reinvestment of interest earned from an investment, rather than being paid out periodically to the investor. (Corporate or government bonds pay out interest periodically, but this is a subject for another time.) Think of compounding as interest on interest, a way of making an investment grow exponentially over time. (Companies typically engage in the practice, using their profit to invest in their own business to become larger.) No less than Albert Einstein is said to have called compounding the “eighth wonder of the world” for its ability to create a large investment return over the long term from what seems like a relatively modest interest rate.
Consider the example of $1,000 invested in a company, fund or other venture that averages a 7% annual return over a number of years. After year one, the $1,000 earns $70; therefore, the investment is worth $1,070. But after the second year, the investment will be worth $1,144.90 – not $1,140 – because the return from year one also has earned interest.
As the process of compounding and reinvesting continues, the original $1,000 by year 20 has grown to $3,869.68. If the interest earned had been paid out to the investor each year and NOT compounded, the investment would be worth $1,000 + (20 X $70) or $2,400. Thus, an extra $1,469.68 is gained from compounding!
Choosing a 7% rate to illustrate this example isn’t coincidental. That’s an approximate compound average growth rate (CAGR) for the entire stock market over many decades. Let’s look at one of the most common indexes of the stock market, the S&P (for Standard and Poor’s) Index of 500 common stocks, also known as the S&P 500.
Since 2010, the S&P 500 has delivered a CAGR of about 10.7%. Using the CAGR calculator to find investment return, $1,000 invested in a fund tracking the S&P 500 Index since 2010 would be worth roughly $2,763.61 today.
Ask Google if investing in the S&P is a good idea, and you get this: “S&P 500 funds offer a good return over time, they're diversified and they're about as low risk as stock investing gets. Like all stocks, it will fluctuate, but over time the index has returned about 10 percent annually.”
How Do I Learn About Long Term Investing?
The public library is a tried-and-true means of finding basic, easy-to-understand books about investing. In the most basic category I would recommend “Investing for Dummies,” which reduces the subject to near-comic book accessibility and will help someone with no clue at all to get started.
For the more erudite, you can’t go wrong with a classic in the field “The Intelligent Investor” by Benjamin Graham. Decades ago, one of Graham’s fans, Warren Buffett, became enamored of his teachings and went on to become one of the most successful investors of all time.
Are There Any Prerequisites to Investing?
Two essentials are the ability to save
and the self-discipline to defer gratification.
In order to invest, a person has to put aside money, in other words to figure out what is necessary to live and to put aside on a regular basis an amount from what is left that will be used to buy stocks, index funds, bonds and other assets. If every single penny is spent on subsistence, investing isn’t an option.
Money put aside as part of the budgeting process – often called a “nest egg” for obvious reasons – constitutes capital for growth. Assuming proper attention to investment principles, the sum generated over time can be used for a college education, a trip, a vacation home, unforeseen circumstances or retirement. The nest egg is supposed to hatch, assuming it isn’t touched too early, which is where deferred gratification becomes important: Putting aside the temptation to spend in order to allow growth and compounding to do their jobs.
Which brings us back to day trading, the opposite of investing. Day traders can be investors, too. Their day job is generating profit from short-term trades. Assuming there is profit, it can then be reinvested properly for the long term. Newcomers to investing would be well served to understand the fundamental differences between the vocation of day trading and the life-long skill of investing.
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Doron Levin is the Editor of BetterInvesting Magazine. His lengthy career includes writing about business and economic subjects for The Wall Street Journal, New York Times, Detroit Free Press and Bloomberg. He is the author of two books and an acknowledged expert on the world automotive industry.