It doesn’t get as much play in the media as it did a decade ago, but even in the strong 2022 market, online trading carries hidden dangers that aren’t always evident at first.
The main risk comes from the fact that online trading may seem deceptively easy. 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.
The apparent ease of online trading may even prompt conservative investors 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.
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Online trading: Lower costs are attractive, but it’s investment quality that makes money
This random element 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.
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.
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 your long-term returns:
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.
Automated stock-picking systems can backfire: Some investors who trade stocks online use automated stock-picking systems to help them make investment decisions. 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.
Bonus tip: Building a “buy and watch closely” portfolio
Of course, 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.
We start by applying our three-part Successful Investor rule for portfolio construction:
Invest mainly in high-quality, well-established companies, with a history of earnings if not dividends;
Diversify across most if not all of the five main economic sectors (Manufacturing & Industry; Resources & Commodities; Consumer; Finance; Utilities);
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.
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.
Note: This post was originally published in 2012 and is regularly updated.
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I will not switch to a broker. I have dealt with 3 brokers in my lifetime, the only time they were interested with me is when I had money to buy more shares. Once the shares were bought I never heard from them as to when to sell any of my shares and take a profit. All they were interested in was their commission on buying shares that their company was pushing.
I have been an on-line investor for over 25 years. I started out with a regular broker (actually I used several as the companies kept getting taken over) but ultimately I realized that the high commissions were affecting my investment decisions, particularly with respect to RRSP investments since my RRSP portfolio was much smaller then.
I moved my accounts to TD Greenline and I have never regretted it. A few years ago, at the suggestion of my bank, I had one of their full service broker advisors look over my holdings to see if there was mutual benefit to moving to the full service model. He was able to offer a wrap account for a percentage of my holdings and he said that they could offer some products (bonds, new issues, flow thoughs) for the same cost as the online broker but, overall his advice was that I still needed the online discount broker account. As a result, most of my investments are still with the online broker but I use the full service advisor for specialized products (mostly flow throughs).
I have access to investment research from 3 brokerages (TD, Scotia and RBC) and I subscribe to TSI and Canadian Moneysaver. The one thing I am missing is an informed second opinion/sanity check but I would never go back to paying up to 5% commissions on each trade.
I started out with a broker, changed to Investorline and when they insisted on a fee for a TSFA, I switched to Questrade. My advisor is the Successful Investor and I am very happy with this setup. I think you have to be aware of the psychology of investing as well as the numbers, and I have learned not to rush into anything.
I don’t know of anything except mental disability that would make me switch to a more managed account.
I have had all sorts of brokers over several years. From this I firmly believe that the only person who cares about your money is YOURSELF!If you go by the brokers recommendation they always have a story to tell as to why your investment does not perform. I subscribe to your service because you never make promises or try to sell anyone on any particular company or market sector. You straight up analyze a company; take it or leave it. Your rules of investing have definitely worked for me. Like Warren Buffett says…I buy companies not stocks.
For ten years in Australia, I had a broker and when I left for Canada I had broken even. I have had three brokers in Canada and all have managed to show a loss of capital, plus untimely advice (Nortel). I have just gone back to a discount brokerage full time in January. Relying on TSI (Wealth) for my advice, my ROI this year is 8.6% so far. How do you ensure you have a good broker? I thought I had one each time. The one person really interested in your investments is yourself, plus unbiased opinion from Pat and similar sources.
I started investing via the mutual fund route where I made money for the mutual fund company. Switched to a full service broker. He made money-I did not. Went to discount online services and my portfolio went from $330K to $600k at which point I decide the use of an expert advisor would be beneficial. Portfolio declined and after 2years I took back control and have just now hit $700K. The expert cost me $200K or more from 2007 to present. (ie. If I still held all the investments I had in 2007 my portfolio would be worth close to $900K)
I have not had a pleasant experience with a broker. A supposedely expert convinced me to sell a stock at 2.40, which eventually went, if you can believe it, to 44.00$ a year and a half later! I could have retired at 45, and am now 57. Like the others above, I am a firm believer that no one cares more about your investments than yourself… so I prefer to accept full responsibility for my investment decisions than to rely on someone else. I subscribe to SPD and TSI for unbiased information, which guide me to make some of my investment decisions. Since I’ve been on my own, things are working out nicely and am satisfied with my portfolios progression.
I have a BMO Investorline account and a Canadian Shareowner account for my RRSP accounts. I am quite comfortable with managing my own investments and have no plans to make any changes.
18 years on my own. Brokers (yuck) Had me selling calls on my great picks and getting taken out and the stock kept moving up. Lots of commisions small profits for me. !% a year advisor was best lots of consulting but then jacked up fee with no warning TOO small acct. Lots of pain “DIY” but only way to learn Keep coming back to the successful investor.
I am now 78 and due to health problems I have a lot of free time to do research and be a DIY investor. I have made errors (Bre-X) but had taken enough out to still realize capital gains before the fraud was discovered.On the other hand I bought 10,000 shares of CNQ in 1987 for 16.5 cents a share in my retirement account (RRSP) and selling 1/2 a yr. later for $1.16. This stock has since gone to $60.00 three times and split 2 for 1 each time. At my age my portfolio is 50% precious metals, 30% enargy and am a firm believer in Uraniums future.
As most of the above comments, I too started of with brokers. Wolfs in sheepsclothing.
TSI and a few others have provided advice over the last 3 decades and for me is the only way to go. No one is more interested in your financial well being than yourself, unfortunately you may not always be the best helmsman. The market is driven by fear and greed, i.e good news at the top, sell and bad news at the bottom, buy. I trade may be too much, but try to enjoy the ride by keeping an eye on the technicals and fundamentals. A large portion in ETFs. Have never lost any sleep yet.
The writer makes a general reference to ” Automated stock-picking systems” . Any thoughts on [A company that markets a computerized stock picking/market-timing service]? I have no desire to use a computerized trading system (or any system based only on a program). Wonder if TSI will include comments to help subscribers.
Pat spoke about stock market software in a previous Investor Toolkit called: How relying on stock market software can steer you into a financial disaster.
Thanks for your comment!
I get tired of reading all the FUD (fear, uncertainty and doubt) that I get from TSI about investing. I am sure there are people who mess up their self-investing, but using the Inner Circle isn’t going to help. With all the people now signed up for it, I doubt Patrick has much time to review each portfolio. So we get a bunch of his helpers who don’t have the experience and follow canned strategies. I know that most of your readers above are very happy with your services. I have not been, but that is my problem. What I don’t like since you started tweeting and trying to be up on modern communication is the silliness of the messages. Old adages reworked. If you want to tweet me about a stock, tell me that I should be buying right now because it is about to go up today. That is what good immediate messaging should do. I don’t need to be told investing truths in instant messages.
The scare tactics in the message above, written so that you can get more advisory business would have been beneath the Patrick McKeough that I followed in the 90’s. Then you simply tried to give good advise and let that speak for you. Now we get bombarded by a lot of shlock. I expect that your advisory is worthwhile, but you have lost focus. I used to get an email that included my newsletter. Now I have to go online to get what I paid for. Nice for you, but inconvenient for me. I am tired of the marketing frenzy and have terminated my subscriptions. Good luck.
Thank you for your very candid comment. I must reply that I believe you are taking a more negative point of view than is justified by our messages. Our story on online trading warns about the excesses that can and do occur when some investors make a heavy commitment to online trading and especially day trading. It is not a condemnation of all online trading. Many potential pitfalls can arise in investing, and understanding what not to do is an essential part of doing the right thing. Pointing out dangers that frequently occur does not necessarily constitute “scare tactics.”
What’s more, I have been consistently more optimistic about the markets and investing opportunities in today’s climate than many who take a relentlessly bearish approach, raving red flags about European debt and other events.
As for your apparent dislike of our marketing, all I can reasonably say is that we are in business and that marketing one’s product to the largest possible group of potential consumers is a universally accepted way of doing business.
I have usedTD “GreenLine” since the mid 1980s, with a couple of short breaks. The more recent short break in 2001, I decided to go with a full service brokerage where you pay a percentage of your assets and they handle all the buying and selling (there were a lot of holdings and I was well diversified). But after a few years of them making more money than me, I got fed up and took my money back to TD discount brokers. I’m happier and making more money. As for the “dangers of online brokerage”, I understand your point about the high volume of buying and selling and losing out on profits by too much buying and selling. I have made this mistake in the past and agree that the low cost of trades makes it easy to get in and out. This could be overcome by a longer term investment plan whereby you decide to hold on to certain stocks for a period of time, as you suggest online and also by way of your newsletter investment strategies. Thanks for the sage advice Pat. Despite my not always following your advice, I have found that you are virtually always right! (Although I have made some decent money on short term buying and selling of DDD and ABX over the last month or so. (I mix buy and hold with very occasional buying/selling short term when there is volatility for certain stocks, but it can be dangerous.))
Is TD Greenline the brokerage that is now called TD Waterhouse? Thanks!
Automated systems have their place. Namely to organize information too voluminous for a human to wade through and make objective sense of. In a way, I look at these systems the same way I look at TSI, a noise filter that (most of the time) gives me a clearer signal; a short-list of companies and ETFs to deep-dive and ultimately make decisions on myself