1.7 Trading in Financial Markets
Now that you have been introduced to various financial products and have a basic understanding of financial markets, you might want to begin investing and trading. The first thing you must ask yourself is, should I manage my investments myself, or hire someone like a financial advisor to do it for me? This really depends on a number of things, a few of which are listed below.
First, how much time and effort can you spend on learning about financial products and markets? If you can take the time to educate yourself financially, then oftentimes you can save money by investing yourself. If you are busy like most people, then finding the time and energy to keep up on everything financial is just not possible. In this case, you might be better off hiring an expert to manage your money.
Second, how much money do you have to invest? There may only be a certain number of financial products within your price range, making it much more self-manageable. Additionally, a common practice in the financial advisory profession is to charge a fee for assets under management (AUM). If you have little money to invest, many financial advisors will not want to take you on as a client, because you will produce very little revenue for them. With that said, some financial advisors will provide planning for a one-time or periodic flat fee. It comes down to how much money you can afford to pay a professional for advice and still have cash left over to actually invest.
Third, when do you need the money back, or how long is your investment time horizon? The decisions involved with short-term investments are often much more complicated than those of long-term investments. Therefore, if you want to invest with a longer time horizon, say at least three years, the advice you will receive from a financial advisor is fairly elementary—buy a stock ETF or mutual fund. However, if you need the money in the near term, then making investment decisions is much more difficult as you cannot afford to lose a substantial percentage of your investment.
Last, but certainly not least, how much self-control do you have when it comes to money? If you need the extra nudge by a financial advisor to even begin investing, then it is definitely time and money well spent. However, if you feel confident that you can make sound financial decisions, even under stress, then you might be better off investing yourself. The problem is, you may not know how you will react to a financial loss until it happens. The biggest mistake individuals make is becoming too emotionally attached to their investments, which leads to bad decisions. A financial advisor will not have that same attachment and, therefore, may be able to make more objective decisions.
Of course, you can do both. You can pay for financial advice for certain things and also invest on your own. If you choose to invest on your own, then the figure below provides you with a simple road map.
Investment Strategy
Before you begin trading, you must establish an investment strategy. The most important decision you make is with regard to asset allocation. How should you distribute your money across the different asset classes, such as stocks and bonds? This should primarily be determined by risk tolerance and investment horizon. Debt securities provide much more certain cash flows than stocks, but on average their returns (income and capital gains) are far inferior. The average annual return on long-term U.S. government bonds over the last 40 years (1982–2021) is roughly 6%, compared to nearly 11% for large company stocks.
If you were to buy $10,000 worth of long-term U.S. government bonds earning 6% per year and hold them for 40 years, they would be worth $102,857.18. Conversely, if you were to buy $10,000 worth of large company stocks earning 11% per year and hold them for 40 years, they would be worth $650,008.67.
These calculations, which you will learn how to do in the time value of money chapter, make it seem like the obvious choice is stocks. However, the largest one-year loss for stocks over the same 40 years (1982–2021) was about -38.5%, relative to roughly +1.5% for long-term government bonds. Therefore, if your investment horizon is relatively short, you probably cannot afford to lose 38.5% of your money. This comes back to the risk-return trade-off discussed earlier. The following table shows several different asset allocation strategies in stocks and bonds by age. The first value is the percent of money allocated to stocks and the second value is the percent of money allocated to bonds (80-20 represents 80% stocks and 20% bonds).
| Age | Low Risk | Moderate Risk | High Risk |
|---|---|---|---|
| 20 | 80–20 | 90–10 | 100–0 |
| 30 | 70–30 | 80–20 | 90–10 |
| 40 | 60–40 | 70–30 | 80–20 |
| 50 | 50–50 | 60–40 | 70–30 |
| 60 | 40–60 | 50–50 | 60–40 |
| 70 | 30–70 | 40–60 | 50–50 |
| 80 | 20–80 | 30–70 | 40–60 |
This table is not supposed to show you how to allocate your money, but rather ought to help you understand that asset allocation is a dynamic process that is sensitive to both risk tolerance and time. After you have identified a broad asset category to invest in, you must then choose a specific security. This process is referred to as security selection. The decision to buy shares of Tesla, Inc., stock is an example of security selection. Now, there is such a thing as over analysis, or analysis paralysis. You might overthink an investment decision, which oftentimes leads to inaction. This is particularly problematic in security selection, as you can miss out on profitable opportunities.
Once you have identified an asset class and security, you are ready to invest. A good investment strategy often takes time and is not a get rich quick scheme. If you want that type of excitement, go to the casino and throw your money on a roulette table. Perhaps the most popular trading strategy is buy-and-hold. You do exactly as the name suggests: you buy an investment and hold it indefinitely. To be confident in this strategy, you need to put forth a fair amount of due diligence in asset research. Only buy a company’s stock if you believe in the company, and only buy a company’s debt if you believe the company can pay you back! Another common strategy is dollar-cost averaging, which is the practice of adding money to your investments in regular intervals. For instance, you can invest $100 every time you get paid from your employer, which is likely to be once or twice a month. Both of these strategies help you avoid the pitfall of trying to “time the market.” You might get lucky once, or even several times, but in the long run you will make a mistake. One bad trade can wipe out years of gains. The S&P Dow Jones Indices documented that over the last 10 years only about 17% of professionally managed funds outperformed a large company stock index. If only a small percentage of professional money managers are able to consistently outperform the stock market, what are the odds you can fare any better?
In his 1973 book entitled A Random Walk Down Wall Street, Burton Malkiel argued that in an efficient market, a blindfolded monkey throwing darts at a newspaper’s financial pages could select a portfolio that would do just as well as one carefully selected by professional money managers. The idea that the prices of financial assets move randomly in the short run encourages the simultaneous use of the buy-and-hold and dollar-cost averaging strategies.
Opening an Investment Account
After you have established an investment strategy it is time to open an investment account. The easiest way to accomplish this is by going to an online broker, such as Fidelity, TD Ameritrade, Charles Schwab, or Robinhood. A brokerage account will enable you to trade a wide variety of financial products, including stocks, bonds, and derivatives. The broker will have you link your brokerage account to your checking or savings account at your deposit institution. This will allow you to quickly and efficiently transfer cash to and from your brokerage account. The downside to a standard brokerage account is that when money is earned on an investment, it is taxed as ordinary income as soon as it leaves the account. There are tax-advantaged retirement accounts that can help you circumvent taxation either on your work income now (traditional IRAs) or on your investment income later (Roth IRAs). We will talk more about these accounts in the retirement chapter that follows.
Submitting Orders to Buy and Sell Financial Assets
To trade a financial asset, an investor generally submits an order through a brokerage firm, which specifies the quantity (size), the market side (buy or sell), and sometimes price. A market order does not specify price and transacts at the best price available at the order arrival time. A limit order specifies price and will transact at that price or better. There are costs and benefits to both order types. With a market order, the price is not guaranteed, so the total amount invested is variable; however, the execution of a market order is near-guaranteed. With a limit order, the price is set, but there is no guarantee that the order will ever transact. Another common condition that must be specified when submitting an order is whether it is classified as a day order, which will automatically cancel at the end of the trading session, or a good-till-canceled order that can stay active for as long as a month.
Monitor Progress and Make Adjustments
Monitoring the progress of an investment and making appropriate adjustments is just as important as the initial decision. It is important to approach investing as a dynamic process that is constantly evolving. The obvious goal in investing is to “buy low and sell high.” However, this is easier said than done, as time changes everything. You might be admitted into a college or professional school. You might get married and have children. You will likely change jobs, or perhaps get promoted. These life events will affect your financial goals and, thus, your investments. Therefore, you need to periodically review your financial position and then take action, such as reallocation across assets or selection of different securities.
A word of caution: you can monitor your investments too closely! One of the biggest mistakes that novice investors make is excessive monitoring of their investment performance. This will often lead to impulsive decision-making, like the sale of a stock that is performing poorly, which can stagnate long-term investment growth. People are loss averse, which means that the pain of losing is far greater than the satisfaction of winning. Reviewing your investments too often will cause you to believe that your portfolio is faring worse than it actually is because you see the day-to-day fluctuations. Stick to your financial goals.