Active trading, which involves buying and selling securities frequently in an attempt to outperform the overall market, may seem appealing to some investors. However, for most individuals, active trading is not the best approach due to the significant risks and challenges involved.
What to know about active trading
“Most people are active in the way they earn income and passive in the way they invest, which statistically is a good thing,” says Matthew Chancey, CFP. He explains that to be an active investor, “you have to have a higher appetite for risk and be more emotionally fortified than every investor sentiment survey has ever suggested that passive investors can be.”
Active trading is often touted as a way to generate higher returns by taking advantage of short-term market movements and price fluctuations. While this is true, it’s important to understand that active trading is a high-risk, high-reward strategy that requires a significant amount of time, effort, and expertise. Chancey advices that successful traders “have to learn how to let winners run, limit losses, properly position size, hedge when possible, learn quickly, and have a short memory—all at the same time.”
Pros of active trading
There are some attractive reasons why the savvy investor might prefer active trading to safer, more passive approaches.
Potential for higher returns: Active traders aim to capitalize on market inefficiencies and price movements, potentially generating higher returns than passive investing strategies.
Flexibility: Active traders can quickly adapt to changing market conditions and adjust their positions accordingly.
Control: Active trading allows investors to have more control over their investment decisions and timing.
Cons of active trading
While active trading can potentially yield higher returns, it’s important to consider some significant risks and drawbacks.
High risk: Active trading exposes investors to increased market volatility and the potential for significant losses if trades go against them.
Time (and effort) intensive: Active trading requires constant monitoring of the markets, analyzing financial data, and making frequent buy and sell decisions. It’s challenging for even professional traders to consistently outperform the overall market over the long term.
Emotional stress: The fast-paced nature of active trading can lead to emotional stress and decision-making influenced by fear, greed, or overconfidence. After all, you’re not as objective as you think—here some tips so that you don’t lose money over it.
Higher transaction costs: Frequent trading incurs higher brokerage fees and commissions, which can eat into potential profits.
The bottom line
“Having the skill to be an active investor is one thing, but having the emotional fortitude is something else that most people lack. Without both,” Chancey explains, “the odds of active trading working out in the long term are slim and none.” For most individual investors, passive investing strategies, such as index funds or exchange-traded funds (ETFs), are often more suitable. These strategies aim to track the performance of a specific market index or sector, rather than trying to beat the market through active trading.
