The Hidden Dangers of Online Trading

The main risk comes from the fact that online trading may seem deceptively easy to those learning how to buy stocks for capital gains, dividend growth or both. The lower costs and higher speeds of online trading can lead otherwise conservative investors to trade too frequently. That can lead you to sell your best picks when they are just getting started. It’s the opposite of what you’ll read in any TSI newsletter. Investors looking for alternatives might consider Canadian etfs as a more stable option.

The apparent ease of online trading may even prompt conservative investors, primarily focused on sustainable dividend growth, to take up short-term trading or day trading. That’s just another danger of trading stocks online—there’s a large random element in short-term stock-price fluctuations that you just can’t get away from. Knowing how to buy stocks online the right way is key to Successful Investing. Knowing how to buy stocks online the right way is key to Successful Investing, whether you’re dealing with individual stocks or Canadian ETFs.

Online trading: Lower costs are attractive, but it’s investment quality that makes money

There’s a random element to investing that can be profitable for short periods. But you can’t reliably profit from it over the long term. In fact, most short-term traders wind up losing money. By the time their beginner’s luck fades, many are trading in dangerously large quantities. This is why some investors turn to Canadian ETFs for a more balanced approach.

If you think the answer to how to buy stocks successfully is frequent trading, beware. As all TSI newsletters point out, frequent trading can also lead you to buy lower-quality, thinly traded stocks. The danger arises from the fact that the bid and ask spreads of many of these investments can be so wide that the share price will have to go up significantly before you’ll even begin to make money on a sale.

You can make trades quickly in online trading, and that cuts your commission costs. However, for successful investors, this is a bonus, not the object of trading stocks. The same principle applies when considering Canadian ETFs.

How to buy stocks successfully

It is far more important to focus on high-quality, well-established companies and how they fit in your portfolio. The longer you hold these stocks, the greater the chance that your profits will improve, as well.

Here are two other dangers to avoid in online trading. Both can seriously hurt the long-term returns that TSI newsletters focus on:

1. Practice accounts can breed false confidence: Some investors are nervous about trading stocks online. So, instead of jumping right in, they start off by using the “practice accounts” or “demo accounts” that the online brokerage industry initiated several years ago. Practice accounts are supposed to be identical to real accounts in all but one respect: you buy stocks in them with imaginary or “play” money, rather than the real thing. The brokerage industry says this gives would-be traders a free opportunity to learn how to trade online without risking any money. Using an online broker’s practice account, you can learn online trading essentials, such as how to enter an order to sell or buy stocks; how to double-check your order before submitting it, so you avoid obvious but common mistakes, like buying 10,000 shares when you only meant to buy 1,000; and so on. The big risk with practice accounts is that you’ll try out a risky and ultimately unwinnable investment approach, like day trading or options trading, and hit a lucky streak. This could embolden you to put serious money at risk just when your results are about to regress to the mean. This will deliver losses instead of profits.

2. Automated stock-picking systems can backfire: Some investors who trade stocks online use automated stock-picking systems to help them make investment decisions. How to buy stocks successfully this way is harder to do. These systems are typically marketed with impressive-looking performance records designed to make investors think they are sure to make guaranteed profits. However, those records are typically derived by “back-testing” the program against past data. In other words, the promoters go back through old trading records and see what would have worked in the past. Automated stock-picking systems essentially do two things: First, they narrow down the data you use when you make investment decisions; second, they apply a fixed rule, or rules, to draw a conclusion or an investment decision from that selection of data. Unfortunately, the market’s key concerns continually change. Today’s good investments can turn into tomorrow’s dead ends. For a time, these systems seem to work, but that’s usually coincidental. If the market is going up and the system tells you to buy volatile investments, it automatically generates profitable trades. But they can just as quickly turn around and begin pumping out unprofitable trades. Often this happens just when they can do the most damage to the investor relying on the system.

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Bonus tip: Building a “buy and watch closely” portfolio

As our TSI newsletters point out, there are a variety of ways to build an investment portfolio. Some work better than others. But our buy-and-watch-closely approach has done well for our portfolio management clients over the past few decades. We recommend this approach for our readers as well as they figure out how to buy stocks successfully. This approach can also be applied to Canadian ETFs.

We start by applying our three-part Successful Investor rule for portfolio construction:

1. Invest mainly in high-quality, well-established companies, with a history of earnings if not dividends;
2. Diversify across most if not all of the five main economic sectors (Manufacturing & Industry; Resources & Commodities; Consumer; Finance; Utilities);
3. Downplay or stay out of stocks that are in the broker/media limelight. This limelight raises investor expectations to dangerous levels. When stocks fail to live up to those heightened expectations, share-price slumps can be swift and brutal.

When figuring out how to buy stocks, it’s important to also know when to sell them. In our TSI newsletters, we advise selling particular stocks when we feel the situation has changed and they no longer qualify as high-quality investments. We also sell if we decide that a stock isn’t as high-quality or well-established as it needs to be, to cope with the challenges it faces. Of course, many of our sales are due to a successful takeover of a company’s stock, which generally results in a major profit for our clients.

In summary, this article discusses the risks and best practices associated with online trading, emphasizing the importance of a long-term, quality-focused investment strategy. It highlights the potential pitfalls of online trading, such as overtrading and the false sense of confidence that can come from practice accounts or automated stock-picking systems. The article advocates for a “buy and watch closely” approach, focusing on high-quality, well-established companies across diverse economic sectors. It also stresses the importance of avoiding stocks in the media spotlight, as these can be subject to volatile price movements. The piece provides valuable insights into when to sell stocks and the benefits of patient investing. Additionally, it mentions canadian etfs as a potential alternative for investors seeking more stability in their portfolios. Overall, the article serves as a guide for both novice and experienced investors, encouraging a thoughtful, disciplined approach to online trading and stock selection to achieve long-term financial success.

Note: This post was originally published in 2012 and is regularly updated.