Online stock investing can look like a great way to build wealth, but it has many hidden dangers.
Trading too frequently: The main risk is that the lower costs and higher speeds of online stock investing can quickly lead otherwise conservative investors to trade too frequently. That can lead you to sell your best picks when they are just getting started.
Trading stocks online may even prompt conservative investors to take up short-term trading or day trading. That’s just another danger of trading stocks online, because there’s a large random element in short-term stock-price fluctuations that you just can’t get away from.
Online trading cuts costs — but investment quality makes profits
This random element can be profitable for short periods. But you can’t reliably profit from it over the long term. That’s why most short-term traders wind up losing money. By the time their beginners’ luck fades, many are trading in dangerously large quantities.
Frequent trading can also lead you to buy lower-quality, thinly traded stocks. The danger here is that the bid and ask spreads of many of these investments can be so wide that the share price will have to go up significantly before you’ll even begin to make money on a sale.
Online stock investing lets you make trades quickly, and cuts your commission costs. However, for successful investors, this is more of a bonus. It is far more important to focus on high-quality, well-established companies, like the stocks we recommend in our Successful Investor newsletter, and how they fit in your portfolio. The longer you hold these stocks, the greater the chance that your profits will improve, as well.
Here are two other dangers to avoid when online stock investing. Both can seriously hurt your long-term returns:
Practice accounts can tempt you to take on too much risk: Some investors are nervous about trading stocks online. So, instead of jumping right in, they start off by using the “practice accounts” that the online brokerage industry recently began offering.
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Practice accounts are supposed to be identical to real accounts in all but one respect: you buy stocks in them with imaginary or “play” money, rather than the real thing. The brokerage industry says this gives would-be traders a free opportunity to learn how to trade online without risking any money.
Using an online broker’s practice account, you can learn online trading essentials, such as how to enter an order to sell or buy stocks; how to double-check your order before submitting it, so you avoid obvious but common mistakes, like buying 10,000 shares when you only meant to buy 1,000; and so on.
The big risk with practice accounts is that you’ll try out a risky and ultimately unwinnable investment approach, like day trading or options trading, and hit a lucky streak. This could embolden you to put serious money at risk just when your results are about to regress to the mean and deliver losses instead of profits.
Automated stock-picking systems can backfire: Some investors who trade stocks online use automated stock-picking systems to help them make investment decisions. These systems are typically marketed with impressive-looking performance records designed to make investors think they have strong track records.
However, those records are typically derived by “back-testing” the program against past data. In other words, the promoters go back through old trading records and see what would have worked in the past.
Automated stock-picking systems essentially do two things: First, they narrow down the data you use when you make investment decisions. Second, they apply a fixed rule, or rules, to draw a conclusion or an investment decision from that selection of data.
The trouble is that the market’s key concerns continually change. Today’s good investments can turn into tomorrow’s dead ends.
For a time, these systems seem to work, but that’s usually coincidental. If the market is going up and they tell you to buy volatile investments, then they automatically generate profitable trades. Then they quit working, and begin pumping out unprofitable trades. Often this happens just when they can do the most damage to their users.
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