Last week, we all watched the ultimate David vs. Goliath battle play out. Members of the subreddit r/WallStreetBets drove up the stock prices for a handful of dying companies, including GameStop, BlackBerry and AMC, thwarting a hedge fund’s plans to short sell these stocks for massive profits.
The short-squeeze of GameStop in particular caused shares to shoot up nearly 2,000% from the beginning of January, though it has since dropped significantly. Some of the young day traders of Reddit were made millionaires overnight ― on paper, anyway. Short sellers, well, lost their shorts.
Clearly, both sides are playing a giant game, with the stock market as the game board, said Pam Krueger, founder and CEO of Wealthramp, a referral service for financial advisers.
“Hedge funds have been gambling like this with leverage forever, unfettered,” she said, adding that Robinhood, the commission-free trading app favored by many Redditors, “has been inciting these day traders to play the game.”
For the average investor, however, it’s a dangerous world to get involved in.
“So many younger people who are betting their 401(k)s and house down payments on GameStop will not have a seat at the table when the music finally stops,” Krueger said. The truth is that Main Street investors shouldn’t get swept up in headlines and worry about what a handful people are doing in the stock market. After all, this type of market speculation isn’t investing, it’s gambling.
So if you’ve been feeling some serious FOMO amid the GameStop market hype, here’s why you should let it go and focus on a long-term ― and boring ― investment strategy.
Don’t Try This At Home
It’s easy to get swept up in the GameStop success stories. One Redditor claimed to use his stock market profits to pay off his student loans. Another paid for his dog’s lifesaving surgery. But that doesn’t mean anyone with a Reddit account and some cash to burn should get into the same kind of day trading activity.
“History shows that timing the market is extremely difficult to do,” said Brittney Castro, in-house certified financial planner for the personal finance company Mint. “It’s a high risk for potential high return, but you can think of it like gambling in the sense that most of the time, you’ll probably lose.”
In fact, only 1% of investors who attempt to time the market do so successfully.
“Like we saw last week with GameStop and AMC, at any given point, there are a number of factors that can come in and completely change the direction of any given stock or market index that may be completely irrelevant to the fundamentals of investing, such as investing in companies with strong balance sheets,” Castro said. Those types of curveballs make successfully timing the market on a consistent basis nearly impossible.
The investors who manipulated the market and made money off a few stocks got lucky, to say the least. But plenty more missed the mark, including YouTuber David Dobrik, who lost $85,000 trying to ride the GameStop wave.
There are also a few financial considerations when it comes to day trading that newbie traders might not think about. Taxes, for example, are a big one.
When you sell investments in a nonretirement account at a profit, you have to pay a capital gains tax. In 2020, the capital gains rate is either 0%, 15% or 20%, depending on your income and filing status ― that is, unless you held the asset for less than a year. In that case, your earnings are taxed as ordinary income according to current tax brackets. And keep in mind that your stock market earnings could bump you into a higher bracket.
So what does make sense as an investment strategy?
“If you want to pick stocks, ask yourself what companies are poised for long-term growth,” said Trevor Ward, a certified public accountant and financial planner at Kinetic Financial. Consider what competitive edge that company has and how it is changing its industry. Ward also recommended looking at its finances ― compare debt to assets and stock price to earnings. You should also understand who makes up the management team.
“If you like what you find, buy it and hold it for at least three to five years,” he said. “If you’re not willing to put in that much effort, investing in index funds and [exchange-traded funds] is a very low-cost way to diversify your portfolio.”
If You Must Engage In High-Risk Trading …
If you are going to dabble in high-risk trading, Castro said you should have a few other things in order first.
Well-funded emergency savings: Before you start investing too heavily, it’s important to have an emergency fund to fall back on. After all, you should never invest money you might need to pay bills or cover an unexpected expense. Having those emergency savings set aside can help you avoid falling into debt if the rest of your cash is tied up in the market.
Adequate insurance: You should also make sure you have insurance in place, such as health, life, home, etc., before getting involved in the complexities of day trading. “Make sure you have ways to protect your money, your assets and yourself,” Castro said.
Clear financial goals: Finally, make sure you are clear on what your goals are. If you feel OK with the risk involved with playing the market and day trading, fine. Castro said it could be a great way to learn the stock market quickly and get a sense of your overall risk appetite and investing philosophy. But that shouldn’t come at the expense of other financial goals, such as saving for retirement or putting your kids through college. “This foundation of having clear goals is a great way to build long-term success that could compliment any short-term gain of day trading you may be able to have,” she said.