The digital age has had a profound impact on global financial markets. Most of the impacts have been advantageous for investors and include the fact that investment information has become readily available and literally right at investor fingertips. This has leveled the investment playing field, with individual investors benefiting as the industry is no longer controlled by a small handful of large banking, brokerage and advisory institutions. Digital information has even revolutionized trading itself as exchange floors are run increasingly by computers, as opposed to physical traders through an open outcry system. (Buying stocks is a careful balance of risk and reward. Learn to identify your risk tolerance and financial goals with these fundamental points. See 4 Key Factors To Building A Profitable Portfolio.)
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There are many benefits to vast volumes of data that are readily available to investors, including the ability to check your portfolio in real time via the internet and through the latest smartphone technology. However, the digital age of investing has led to excessive trading, which can be very dangerous to your portfolio. Below is an overview of three of the most serious disadvantages it can place on investors.
Checking your stock portfolio everyday and trading too often can increase your tax bill. Taxes on stocks occur only through realized gains, and short-term realized gains are taxed at the same rate as an investor's regular income, or namely his or her highest marginal tax rate. Long-term taxable gains are more reasonable at 15%, but this is still much higher than 0, which is what investors pay by holding a stock and locking up appreciation in the form of unrealized gains.
Using options is another shorter term trading strategy that is relatively tax inefficient. Options weren't invented as part of the digital age, but the ability to obsess over short-term price fluctuations has made options a more integral part of the trading habits of many investors. As the vast majority of options, including the most common put and call options, are held less than a year, they qualify as short term and are taxed at ordinary income rates. (The option to bolster after-tax stock returns through tax-loss harvesting can reverse investor gloom. check out Tax-Loss Harvesting: Reduce Investment Losses.)
Excessive Trading Costs
Trading stocks often is nearly certain to increase trading costs. Many discount brokers offer equity trades for less than $10 these days, but these trading commissions can still add up for investors that trade excessively. The costs can really add up for day traders as they can rack up hefty trading commissions and must also pay short-term tax rates for realized gains.
Bid and ask spreads are not explicit trading costs, but can greatly affect overall gains in stock portfolios. For liquid securities including blue-chip stocks, the spread is usually not significant. However, for smaller and other illiquid stocks, spreads can be substantial. As the investor must buy at the asking price, or price a seller is willing to offer the security, and sell at the bid price, or price a buyer is willing to pay for the security, a wider spread eats into eventual gains and increases losses should the stock fall in price after purchase. (Discover how investment strategies and expense ratios impact your mutual fund's returns. See Stop Paying High Mutual Fund Fees.)
Many investment professionals have pointed out that it is extremely difficult to beat the market. The "market" is usually defined as the Standard & Poor's 500 Index, or an index fund that holds 500 of the largest publicly-traded companies in the U.S. The index itself is much like a buy-and-hold portfolio as turnover is low. The index is rebalanced only on an as-needed basis, such as if a company is bought out and needs to be replaced in the lineup of 500 names.
Given that most indexes are built for the long term and trade infrequently, they are tax efficient and commission costs are held relatively low. As such, any investor that trades too often is automatically at a disadvantage as higher taxes and trading costs make it very difficult to beat the market over time.
The bottom line is that checking your portfolio too often can lead to too much buying and selling activity. For the reasons cited above, excessive trading can put investors at a disadvantage when it comes to growing their wealth over time and beating major stock indexes. A final consideration is that trading excessively can be stressful because watching the market on a real-time basis is tiring, as is having to track all of the paperwork for tax purposes that comes with making too many trades.