Should You Trade Stocks?
New companies like Robinhood have pushed the envelope of the financial services industry and made it easier and cheaper than ever for individuals to trade stocks on their own.
When I got started trading, you had to pay a fee ($30ish) for each trade that you called in to a broker, and then had to pay a monthly fee for the privilege of having an account if you were a small trader.
Now, there are no fees to have an account, no fees to trade most stocks and ETFs, and no fees to trade many mutual funds too. As trading access and pricing has become more democratized and COVID has forced people home with extra time and money to spare, the numbers of people trading has exploded and lead to massive volume trading events like GameStop, AMC, Tesla, and the like.
So, should you wade into the madness that is trading stocks?
Short answer: If you want to, yes!
New companies like Robinhood have pushed the envelope of the financial services industry and made it easier and cheaper than ever for individuals to trade stocks on their own.
When I got started trading, you had to pay a fee ($30ish) for each trade that you called in to a broker, and then had to pay a monthly fee for the privilege of having an account if you were a small trader.
Now, there are no fees to have an account, no fees to trade most stocks and ETFs, and no fees to trade many mutual funds too. As trading access and pricing has become more democratized and COVID has forced people home with extra time and money to spare, the numbers of people trading has exploded and lead to massive volume trading events like GameStop, AMC, Tesla, and the like.
So, should you wade into the madness that is trading stocks?
Short answer: If you want to, yes!
Trading stocks is a great way to become an active participant in the financial world and have fun while (hopefully) making a bit of money. It is fun to own a piece of a company you know and maybe love. I highly recommend it for those that want to become involved in it.
However - as with any short answer - there is always a long answer.
Long answer: If you want to, yes... as long as you take some other critical elements into mind before you go forward with it.
FOLLOW ALONG FOR SOME QUESTIONS TO ASK YOURSELF BEFORE YOU START INVESTING IN INDIVIDUAL STOCKS!
Investing in individual stocks is one of the riskiest forms of investing.
When trading individual stocks there are unlimited numbers of factors that can influence the prices of individual companies in drastic ways, both good and bad. The best organizations in the world can see their stocks fall on the slightest of negative news. Sometimes even on positive quarter or year end numbers you can see the price of a stock fall. There are no guarantees.
One of the best benefits of mutual funds and indexes/ETFs are that you have exposure to several (hundreds or even thousands of) companies. The risk can be spread out amongst these companies and if they are mostly good companies that are continuing to grow, you will make money over time even if one or a few don't. That is why these types of investments are recommended for long term retirement savings.
Individual stock picking/investing SHOULD NOT form the backbone of your retirement investing. This kind of investing should be COMPLETELY SEPARATE from your general retirement savings. You cannot risk the money you will need to ensure a comfortable retirement on the whims of the market.
You also need to ensure that you have a solid Emergency Fund (3x to 6x your monthly income needs) in cash in the bank first, that way you aren't risking money money you would need in case you lost your job or had some other unexpected emergency.
If you are putting money from your monthly income into an account to trade with, it needs to be extra from your monthly budgetary needs. Think of the money as coming from your entertainment part of your budget. Rather than going out to dinner that week, or a movie, or buying something fun you are going to use that money to trade.
That way, if you win, great! You have more money!
If you lose, that's okay! It was fun, and hopefully you learned something from the trade that will make you better on the next one!
Are you comfortable with large swings in stock prices?
Would you be okay if you lost 20% or more of your investment overnight?
Is this money that you can afford to lose all of? If the money disappeared would it hurt your family financially?
Are you willing to do the work?
You have to be willing to put in the work to be successful at trading stocks. You have to be willing and able to spend the time to do your due diligence and research the companies you want to invest in to develop a thesis as to why this is a good investment.
Can you afford to spend the time it takes to do the proper research to make the best decision on which of the millions of companies to buy a piece of?
Is there somewhere else that your time could be better/should be spent?
Do you have access to or know where to look for this information?
You also need to understand the various kinds of trades you can make. For most traders, sticking to normal common stock is the way to go. Even within that you can buy and sell at market prices, can place limit orders, stop orders, trailing stops, stop limits, etc. You could also trade warrants on some stocks. Some people may want to dabble in options, for which you need to know the difference between a call and a put, what a strike price is, when a contract is in the money and so on.
You need to develop a strategy for the kinds of trades you are going to place beyond which companies to invest in.
Important note: DO NOT TRADE ON MARGIN until you are very experienced as a trader (think years), and never trade on margin unless you have the excess cash/stocks elsewhere to be able to liquidate to cover a loss/margin call. It is like buying stock on a credit card and has broken many traders. Best to steer clear completely. If you don't understand what I am taking about, stay away!
Are you willing to put in the time it takes to learn about your different trading options?
Do you understand the different trading options that are available to you?
Have you developed a strategy for the kind of trades you are going to make?
You must develop a thesis for each potential investment!
You have be able to develop an investment thesis for each trade that you are going to make. This should be a statement about why you would invest in a particular company. You should be able to explain your thesis to a stranger in 15 seconds or less and the stranger be able to repeat back why it would be a potentially good trade to make. If you cannot break it down that easily, then it isn't well developed enough to trade upon.
Questions you need to be able to answer for your investment thesis:
Is this stock undervalued? What measure are you going to use to define value?
What are the financial prospects of the company (current and future)?
Are the economic and political environments for the company/industry favorable or trending towards favorability?
Is there a specific catalyst that is going to drive the price of the stock higher?
What is the potential risk for the investment/most you're willing to lose? What is the reward you can reasonably expect?
If the stock isn't undervalued, why would you buy it? You probably shouldn't. There are any number of metrics you could choose to define value (P/E ratio, P/S ratio, P/B ratio, stock price relative to sector/competition, growth prospects, etc.). So you have to decide how you will define value and use that to measure one investment option versus another.
Part of the valuation is going to be determining the financial prospects of company. Are they turning a profit? If not, have they demonstrated a clear path to get there and beyond? Do they have a lot of debt? If they do, are they at least using the debt to fuel more growth? Are they in a solid enough financial place that they can weather an economic demand downturn that lasted more than a couple of quarters?
Tying into this, you must assess the economic and political environment and how favorably the company is set up to take advantage of them, or certainly not be hurt by them. For instance, under the Trump administration it was politically favorable to be in certain industries (Oil and Gas, Private Prisons, etc.). Under the Biden administration, those are generally not going to favorable industries, while others (Electric Vehicles, Marijuana, etc.) are potentially going to be better set up to take advantage of the political environment in the next few years. For the economic factors, look for industries that trend well with the current economy, or what you believe is going to happen in the coming months/years. For instance, in economic downturns, consumer staple companies (like food producers, utility companies) are generally going to do well, while consumer discretionary companies (car manufacturers, travel) tend to underperform.
What is the catalyst that is going to drive the stock forward? What is going to happen that is going to cause the price of the stock to increase? It could be that a company is going to come out with a new product that is going to bring in new customers. Maybe they have a unique offering that is going to steal market share from a competitor. Are they disrupting an industry and have lots of growth potential? You need to see an opportunity/advantage that really gives your company potential to grow and it's stock price along with it.
Risk/Reward. How much do you expect to reasonably gain from making a trade? Do you expect 20% upside in the next year? Why? 100% over the next three years? This where the bigger analysis along with the catalyst will determine your projections. What is your exit strategy when you start reaching your goals, how are you going to sell out of the position? What is the most you are willing to lose before you start selling and moving on to the next investment? The risk and reward parameters are your guide to when to exit the trade. When you make enough or lose too much, time to get out and find the next company to invest in.
WHAT YOU CANNOT DO is follow the crowd. Don't play stock just because they are hot. For instance GameStop in it's big run up at the end of January/beginning of February 2021, people started jumping in knowing nothing about the company. Think about how trades work. A price for stock is determined at any given point in time based upon the last transaction that took place. Someone has to sell a share of the stock and someone else buy it, and whatever the last price a trade happens at is this new price. So when $GME ran up over $400, someone bought one of those shares, and with the stock price well below $100/share now there are plenty of people who bought shares and have lost real money.
If they had developed an investment thesis for their trade, it would have not held up and they would not have traded GameStop stock.
To Wrap It Up:
Is this money you can afford to lose?
Don't play with money you can't afford to have disappear if something goes wrong, or that you need in an emergency. Trading stocks is not for your retirement investing.
Are you willing to do the work?
Investing is a zero sum game. For you to win, others have to lose, and you are playing against computers and professionals that don't often lose. The best way to do this to pick good companies in good situations and hold them over longer periods of time. You have to be willing to do the research to understand the different kinds of trades you can make and develop your strategy for executing your trades.
What is your investment thesis?
You have to be able to assess each company, and then be able to express in a short statement why you think this is the right company to invest in at the right time, including outside factors identify a catalyst that will drive the catalyst higher. You need to identify your realistic risk/reward potential for the stock and be ready to sell the position when you reach one of the parameters.
Where does stock trading fit within your overall Financial Plan?
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