Precautions for Young Traders

Market displacements over the past 4 months have led to a massive boom in American trading activity. The extreme volatility, unusual amount of free time due to working from home, and availability of trading apps has led to more Americans day trading than ever before. According to popular mobile trading app Robinhood, they have added more than 3 million users year to date. More than half of these users are millennials who are opening an investment account for the first time. Everything considered, I think this is great for the world of finance that younger investors are getting involved. However, I think there are some important precautions I would like to raise to this generation of traders.

1. Stocks do not just go up

   • Alright, well maybe since late March they have pretty much gone straight up. But context is important, this recovery is a very unique period for the market. I give massive credit to Dave Portnoy, CEO of Barstool, on igniting trading interest with his viral DDTG videos. I personally think they are extremely entertaining and I applaud his ability to garner a younger audience’s attention to trading as nobody has done before, but please recognize the sarcasm and entertainment value in much of his advice. Investors need to be prepared for volatility and to have a plan for when markets inevitably turn in the opposite direction. The old investing saying “a rising tide raises all ships” is in reference to what this past 3 or so months has looked like. Complacency can lead to some of the worst investing mistakes. Please be aware that this investing environment is not normal.

2. Beware of the urge to hit a “home run”

   • One of the biggest misconceptions about investing, or trading, is that that it will lead to overnight riches. This is almost never the case. Building wealth through investing is about consistency and time in the market. Sure, there are some investors who have gotten in early on unicorn companies and made an absolute killing - and good for them! But recognize that this is the small minority of investors. Investing is about participating in market returns over time, not hitting an overnight success.

3. Diversification is your friend

   • Building off of the previous point, beware of over concentration within certain positions. Having conviction about a certain company, or industry, does not necessarily mean you need to have 60% of your portfolio invested in it. Identify a handful of areas you are interested in and do your own research on those companies. The most basic idea behind diversification is that it’s better to have exposure to 3 companies, than 1 company. If you have exposure to 3 companies then your portfolio will not be as sensitive to the performance of 1 among them. If you only have an investment in 1 company, your portfolio’s performance is tied directly to theirs.

4. Understand the difference between day trading and investing

   • This might be another misconception to newer entrants to Wall Street, but day trading and investing are not the same thing. I would liken Day Trading to gambling more than anything. Day trading consists of jumping in and out of individual names in an effort to catch and ride intra-day price swings. These are typically short term moves caused by headlines or other trading activity. Investing, on the other hand, is a long term participation in the market. Investing rewards diversification, time in the market, asset allocation, and rebalancing. People day trade to get rich quick, while people invest to build wealth over time. Day trading has proven to be an increasingly difficult feat. Technology has created an environment of instantaneous information availability, algorithmic computerized trading, and massive automated rebalancing - these are all factors a day trader is competing with from their smartphone. Perhaps the most difficult part of day trading is having the ability to buy and sell, to jump in and out of a position, at the right pricing. If you think about it, this requires the investor to be right twice - they need to know when to sell out of a position and exactly when to buy back into it. There is a reason that the average investor only earns about 1.9% per year (you wont hear anything about that stat on instagram.)

5. Beware of leverage

• One gripe I have with some of the trading apps is the ease at which they allow inexperienced investors to utilize margin. Margin trading is when someone uses borrowed funds from a broker to trade a financial asset, which forms the collateral for the loan from the brokerage. We saw an extreme version of this a couple of years ago when people were mortgaging their homes to purchase cryptocurrency. When used properly, margin has the ability to greatly amplify returns, but it also has the likely ability to deeply intensify losses. If a trade flips on you and you have margin in place, the brokerage house could force a margin call and you may be forced to either add cash or to liquidate the position.

Make no mistake, I am all for younger / inexperienced investors taking an interest in Wall Street and investing. I think it’s fantastic that apps and social media personalities have reignited the american interest in investing. I do, however, think there is a right way to do things and a wrong way to do things. Unfortunately, a lot of the hype around the trading topic has seemed to glorify risky trading tactics and has underplayed some of the major risks with investing. Remember, day traders typically do not post their failures, only their wins.

Investing is something I encourage all young people to get into. However I encourage you to take your time, do not invest more than you are willing to lose, and focus on educating yourself before pushing “the button.” A wise investor once told me that “if you can’t explain it, you probably shouldn’t be investing in it” and I think that perfectly sums up my cautionary tale.

If you have any questions about getting started, or if you’d like to have your investment account professionally managed, please reach out.