Who hasn’t met or heard of a person who claims to have earned a sizable amount of money trading stocks?
It’s tempting to believe that stocks are a fast, sure way to wealth. It’s just not so. Stocks can indeed provide opportunities to achieve good returns, but there’s risk involved. Understanding the difference between risk and reward is extremely important.
Before we get to the big question, how does one make money in the stock market, let’s first answer a small, but equally important, question.
Investing vs Trading: What’s the difference?
Before you consider the stock market, ask yourself this: Am I an investor or am I a trader? The distinction between the two is large, and boils down to investing time horizons.
Investors approach earning money on the stock market as a longer-term goal. They buy stocks and hold on to them for an extended time period – often months, years and even decades. They’re more risk-adverse than traders.
Traders are all about the short term. They will buy and sell stocks daily or weekly with the goal of taking advantage of rising and falling markets. The fabled day trader will buy and sell stocks multiple times a day which may leave traders with smaller, more frequent profits or losses.
How does the investor make money in the stock market?
To the committed investors, time is a friend not an enemy. They’re patient by nature, seeking the gradual building of wealth over a longer time period. They are graduates of the Buy-and-Hold School of Investing.
They stay invested in the markets, thick or thin, buying and holding stocks, mutual funds, bonds and other investments. Along the way to achieving their financial goals, investors take advantage of compounding interest and dividends to boost their portfolio performance.
While investors don’t like market fluctuations any more than anyone else, they’re more accepting of downturns. The expectation is that stock prices will eventually rebound and they’ll recoup any losses.
Because they value consistent returns over a longer time frame, investors will pay more attention to price-to-earnings ratios, management forecasts and other fundamentals.
Investors know that, as stocks are purchased and sold, their portfolios can fall out of balance with their investment plan. That’s why they regularly rebalance investments, ensuring they are reflecting their financial goals.
In the Investor’s Toolkit: Dollar cost averaging
Dollar cost averaging, also referred to as systematic investing, fits the long-term mentality of investors. This well-known investment strategy calls for the investor to use smaller amounts of money to purchase specific stocks at pre-determined time periods, usually weekly or monthly.
Because their purchases are spread out over market cycles, investors will sometimes pay more and sometimes less for the same stock. These differences are averaged out in the long run, helping reduce the more serious impacts of market fluctuations.
In the Investor’s Toolkit: Diversification
Another oldie but goodie. Diversification involves spreading money among different asset categories with the expectation that, if one investment loses money, the others will make up for it.
The “Trader” mindset
The goal of every trader is to generate returns that beat the investor’s buy-and-hold investment strategy. They do this by frequently buying and selling stocks and other investments.
As the old adage goes, “Buy low. Sell high.” Profits are generated by buying a stock at a lower price and then selling it at a higher price within a fairly small time frame, often in the same day.
Experienced traders will also “short a stock”. This is the reverse strategy, where a trader will “Sell high. Buy low”, as there must always be two entries to profit. However, the difference is that the trader must borrow the security first from broker or dealer in order to have the security to sell. At some point in the future, the trader will be required to return all the borrowed shares – hence the reason they must buy back these shares. If the price did in fact drop, and the trader rebought these shares in the market at a lower price, they have effectively bought at a low price and sold at a high price (again, just the reverse order). This type of trading is much riskier and should be reserved for experienced and knowledgeable traders
The Exit Strategy
Experienced traders will spend as much time considering when to sell a stock as when to buy it, often establishing this figure before even entering the trade. The “exit strategy” is vitally important to locking in profits while minimizing losses. Let’s quickly touch on the two main actions within an exit strategy.
- Stop-loss: The price at which you’ve decided to buy or sell a stock. The stop can help lessen losses if the stock price moves against your position.
- Take-profit: The price at which you’re content to close your position and take a profit.
What type of trader are you?
Many factors go into defining one’s trading style, including experience level, size of portfolio, tolerance to risk and, let’s face it, the amount of time available to research and trade stocks. Trading stocks can, and will, occupy big portions of your day if you let it. Generally, there are four trader types:
Scalp Trader: This type of trader is motivated by making small profits over dozens of trades every day. Some of their positions are held for mere seconds!
Day Trader: This individual will trade multiple times throughout the day with the goal of making the most of fluctuating market prices.
Swing Trader: Swing traders will look for, and react to, changes in a business’s fundamentals. They tend to hold on to stocks for several days and even weeks, keeping an eye on any price movements that could trigger a profit.
Position Trader: These traders hold on to stocks for weeks to months. They are not especially active, trading perhaps once a month.
In the Trader’s Toolkit: Research & trading must-haves
Your personal trading strategy and preferences will dictate the best tools for you.
With that said, there are some essentials that make the business of trading more enjoyable – and potentially rewarding. Real-time data, for instance, is critical when you consider that a stock’s price may go up or down in no time. Let’s touch on some of the most popular tools that help both traders and investors:
Stock screeners: These scan markets to give you the latest on a range of actionable updates, such as trading volumes, stock prices, chart patterns and more. You can customize stock screeners to your goals and interests.
Charting: By visualizing the performance of a stock in lines or candlesticks, charts can assist traders in deciding when to buy and sell.
Third party research: Respected brokerages offer traders a vast array of third-party investing research. The insights are there to be discovered. All you need is the time and patience to dig deep.
Technical analysis: A suite of products gives you the knowledge you need to recognize key market events and investment patterns. Technical analysis can help investors make more informed trading and investment decisions.
Practice accounts: If you’re new to trading or simply want to build your investing skills without risking real money, consider a practice account. The Scotia iTRADE Practice Account [link] will provide you with a fictional portfolio worth $100,000 CAD and $100,000 USD. You can trade stocks, test your trading strategies, and try our investing tools (like research, stock screeners and charts) risk-free and fee-free. Learn more [link]
How to compare your returns against benchmarks.
Every trader and investor strives to beat the market. But when do you know that your investing strategy is successful?
By comparing your performance against a benchmark, in most cases a market index like the S&P/TSX Composite. There are dozens of benchmarks from which to choose. However, benchmarking can never be a precise science because your portfolio, trading or investment strategies are unique. The difference between your portfolio’s performance and the benchmark is known as the tracking error.
In addition to returns, benchmarks can also help investors assess their strategies, including their individual approaches to risk.
Stocks or Index Funds: Which is right for you?
On the other hand, index funds, also known as equity index funds, are like mutual funds. They’re comprised of sometimes hundreds of different businesses. As the name suggestions, index funds track the performance of a specific indices such as the S&P500 and TSX60 .
Which one is best for you?
Investing in stocks
Some pros and cons of investing in individual stocks:
- Potential to beat the market. It’s hard for an index fund to compete with a company on the ascendancy, especially one that has transformed an entire sector. Consider Amazon and Apple.
- Potential to lose money. Stocks can open up your portfolio to more risk, because the prices of individual stocks fluctuate more wildly than funds do.
- You’re in the driver’s seat. If you like researching stocks and the control that comes with buying and selling them when you want, individual stocks could make more sense for you.
- How they’re taxed. Should you sell a stock at a higher price than you paid for it, you'll need to add 50% of the capital gain to your income.
- No management fees.
Investing in index funds
Some pros and cons of investing in index funds (or equity index funds):
- For the more risk-adverse. The key benefit of index funds is that they aim to keep pace with the index they track. The fund’s overall returns won’t be strongly impacted by the lackluster performance of one or two companies within the fund.
- You enjoy instant diversification. As an index fund owner, you indirectly own parts of hundreds of businesses.
- Ideal for a passive investing style. Unlike traders, investors prefer a more passive investing style. This approach strives to mirror the performance of the market rather than trying to beat it.
- You prefer leaving trading decisions to others. Don’t have the time or the aptitude to research and buy individual stocks? Index funds are professionally managed, and come with MERs to remind you of the fact.
- They’re not ideal for short-term goals. Index funds are made for longer-term strategies. Because they’re passive investment vehicles, performance is pegged to the market and you’re not protected against downtrends along the way.
- How they’re taxed. While you own the index fund, you’re taxed on the distributions of income that are flowed out to you. When you sell or redeem the fund, you’re taxed on the gain, if any.
Challenges & Watch-outs: Factors to avoid when money in the stock market.
Emotional trading: Don’t let feelings and emotions like panic, impatience, fear or over-confidence influence how you trade. The same applies to falling in love with a particular stock. Gut feelings have a place, just not in the stock market.
No clear plan: Your investing strategy should include more than “make lots of money in the stock market”! A seasoned trader will have an entry and exit strategy. They’ll know the amount of money they have to invest. And the amount of money they’re willing to lose.
Bottom fishing or timing the top: This is a strategy dedicated to trying “catch” a stock at its lowest price. Conversely, there’s timing the top during a market rally. Predictions of any kind always come with a degree of risk in the stock markets. These two approaches are no different.
Hot tips: When it comes to promising stocks, there’s no shortage of advice to be found. Proceed with caution and, when in doubt, stick to your strategy.
Investing on your own can be a very rewarding experience. Both investors and traders speak of the personal sense of empowerment they feel taking more control of their financial picture.
Success lies in knowing who you are as an individual. How much time do you want to spend trying to make money in the stock market? Are you looking to accomplish frequent daily trades or is your goal to bolster your retirement savings? How risk-tolerant are you really? After all, you can’t influence what the stock market does but you can control how you react to it.