We take a hard look at the risky aspects of online trading and what they mean for you as an investor
Online trading seems like an easy and convenient way to invest, but that can also make it an easy way to lose money.
What is online trading? Some investors may look on online trading as a fairly quick and convenient way to build wealth, but there are many hidden dangers that may not be easy to spot at first.
The main risks of online trading come from the fact that it all may seem deceptively easy. The lower costs and higher speeds of online trading can lead otherwise conservative investors to trade too frequently. As a result, you could wind up selling your best picks when they are just getting started.
The apparent ease of online trading may even encourage conservative investors to take up short-term trading or day trading. That’s just another danger of trading stocks online—there’s a large random element in short-term stock-price fluctuations that you just can’t avoid.
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When beginner’s’ luck fades, investors are in dangerous territory
This random element can be profitable for short periods. But you can’t reliably profit from it over the long term. In fact, 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 arises from the fact 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.
You can make trades quickly in online trading, and that cuts your commission costs. However, for successful investors, this is a bonus, not the object of trading stocks.
It is far more important to focus on high-quality, well-established companies 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 risks of online trading that frequently crop up with online trading. Both can seriously hurt your long-term returns:
1. Practice accounts can breed false confidence: Some investors are nervous about trading stocks online. So, instead of jumping right in, they start off by using the “practice accounts” or “demo accounts” that the online brokerage industry initiated several years ago.
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. This will deliver losses instead of profits.
2. 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 are sure to make guaranteed profits.
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.
Unfortunately, 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 the system tells you to buy volatile investments, it automatically generates profitable trades. But they can just as quickly turn around and begin pumping out unprofitable trades. Often this happens just when they can do the most damage to the investor relying on the system.
Knowing the risks of online trading, what are some other online trading topics you’d like to see us cover? Let us know in the comments.
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