Sean Pyles: Welcome to the NerdWallet Smart Money Podcast, where we typically answer your personal finance questions — except for this episode, where we are continuing our three-part series about how to get started investing. I'm Sean Pyles. Last week we talked about different types of investments. And this episode, to wrap up the series, we're going to talk about how to manage risk and return when investing.
If you have any questions, thoughts, comments, etc., about investing, share them with us on the Nerd hotline by calling or texting 901-730-6373. That's 901-730-N-E-R-D. Or you can email us at [email protected].
Hearing from all of you is one of the best parts of the show. So please keep your comments coming. And as always be sure to download, rate and subscribe. OK, on with the show. This week I'm joined yet again by my partner for this series, investing Nerd Alana Benson. Hey, Alana.
Sean: Here we are in the third and final installment of this miniseries about investing. In the first week we talked all about the roadblocks that people run into when they try to start investing and how they can overcome them. Last week, we talked about the different types of actual investments, like stocks and bonds. So, Alana, what are we talking about today?
Alana: Today we're going to focus on some different investment strategies and how they can help or hurt your investment journey and then how to balance risk and return when you're investing.
Sean: All right, it sounds great. Let's start with talking about investment strategies. And, what exactly do you mean by the word strategy in this context?
Alana: So there are a lot of different schools of thought when it comes to investing strategy, but most of them revolve around how you can build your portfolio to make you the most money. So we're really going to focus on two of these. We're going to talk about day trading and buy and hold.
Sean: Day trading is a topic that we've been hearing a lot about in the past year with the rise of beginner investors using Robinhood and Reddit. Can you explain exactly what day trading is?
Alana: Yeah, happy to. With day trading, your strategy is all about short-term stock trading. Sometimes you're buying and selling within a single day, as the name sort of suggests, and the goal is to earn a profit from each trade by timing the market, which maybe isn't the best idea.
Sean: Yeah, exactly. For some people, this idea can sound like a lot of fun, but the truth is that timing the market is super risky and very few people actually earn money by doing this. In fact, a 2010 study by Brad Barber at the University of California at Davis suggests that just 1% of day traders consistently earn money.
Alana: I'm so glad that you mentioned that, because day trading has really entered the mainstream in the past year with the rise of meme stocks, like GameStop and AMC, and even cryptocurrencies, like your favorite Dogecoin. But a lot of this is facilitated by apps like Robinhood, where trading is gamified — and full disclosure, Robinhood is a NerdWallet advertising partner — but some of these brokerages can use different techniques like psychological tactics that can help encourage you to day trade even if it's not the best thing for you.
Sean: And unlike losing something like a game of Two Dots, my favorite iPhone game, if you lose when you are doing day trading, that's your actual money on the line.
Sean: It's also worth noting that the Security and Exchange Commission, a government agency which enforces laws against market manipulation, generally discourages day trading. For most regular people it's not very accessible, since professional day traders are using expensive technology and technical analysis to find intra-day trends that they hope to capitalize on, which is how they can make money.
Alana: Mm-hmm. And that expensive technology and technical analysis is what separates the amateur day traders from the pros. And that's part of why it's so hard for the average Reddit investor to make money from day trading. Pros know the tips and tricks and have access to data subscriptions and personal connections that other folks don't have. And even then, they often get it wrong. So, it's something to be cautious of.
Sean: Yeah, but at the same time, the pros actually welcome more amateur investors into the world of day trading because the more folks that are putting in and losing money, the more the professionals have to gain.
I also want to talk about the potential tax liabilities of selling stock in this way. What should people know here, Alana?
Alana: So, basically, if you make money selling a stock, which is the whole point of buying them, you will likely have to pay what's called capital gains tax on the profit that you make. And you sort of touched on this. But how much your profits or gains are taxed has to do with how long you've held on to the asset. If you hold the asset for less than a year, these profits are subject to short-term capital gains tax, which equates to your ordinary income bracket. If you hold those assets for more than a year, you'll likely have to pay long-term capital gains tax on them, which are usually lower than those on short-term capital gains.
As you can imagine, this can get pretty complicated, and it's definitely worth consulting with a tax professional if you think you'll be dealing with capital gains of any sort.
Sean: Yeah. That's great advice. Now I want to talk about the risk versus return question of this strategy. What are your thoughts here?
Alana: As we've been sort of hinting, despite all the hype, for beginner investors day trading has the most risk for the least amount of reward. As we talked about in our last episode, trying to predict the market is basically impossible. And since experts get it wrong all the time, you may call a market trend and make a lot of money at some point, but it's highly, highly, highly — and I can't stress this enough — unlikely that you'll be able to do it over and over again and continually beat the market. And that's why day trading is typically not a great idea for most people, especially beginner investors, which brings us to the buy and hold strategy.
Sean: Indeed, excellent segue, Alana. The buy and hold strategy is a much less chaotic and generally more reliable way to invest. Can you give us a quick rundown of how it works?
Alana: Yeah, sure. So with buy and hold, you do exactly what it says. You invest in a stock or an index fund and then sit on it for years or decades. So this passive investing strategy is generally seen as one of the best ways for building long-term wealth.
Sean: The idea is that when you hold on to an investment for a long time, you're able to ride out any short-term volatility in the market.
Alana: This is pretty much the opposite of timing the market. And it's a practice that famous investors like Warren Buffett swear by. It's all about finding companies or funds that you think will perform really well over a long period of time and not dropping them when there are small dips in the market.
Sean: And, one perk of buying and holding is that it can help you invest and grow money for a goal that's years away, like buying a vacation house or saving for your kids' college education.
So far, we've talked about why buy and hold might be a safer way to invest compared with day trading but Alana, can you talk about how folks can actually go about enacting the strategy? Is the classic brokerage account how most folks go about it?
Alana: You can definitely do the buy and hold strategy from a standard brokerage account, but you could also do it from an IRA. You can even do it through a robo-advisor. So, doesn't matter where your stocks are held, because remember those are all different types of accounts, but all you have to do is just not sell your investments when the market drops.
If you buy Tesla stock and it dips when oil gets really cheap, the idea is that you would keep holding on to it because you believe in its long-term potential. And that belief should be backed up by actual numbers, and you can look at the company's performance and history to inform those opinions. And again, that's just an example. That's not personalized investment advice.
Sean: And now let's turn to the risk versus return question. How does that play out for the buy and hold strategy?
Alana: This route offers the best likelihood of a return for the least amount of risk. It may not be as sexy as something like day trading, but that's fine because this has historically been one of the best ways to actually grow your money in a reliable way.
Sean: How much money or wealth can folks hope to build with the buy and hold strategy? What sort of returns can people expect?
Alana: OK, so just to hedge this, and we say this until the cows come home, but no returns are guaranteed and there's always the risk of loss when investing. That being said, the average annual return is 10% before inflation. And inflation can eat away your returns, which is another argument for investing in general. But if you're not investing, you're not outpacing inflation and your hard-earned savings will lose purchasing power over time.
Sean: I'm feeling like my investment decisions so far have been validated. I love to invest in something and then really never touch it again until years later, which brings me to a topic that kind of straddles both day trading and buy and hold, which is cryptocurrency. As regular Smart Money listeners may know, I have a bit of Dogecoin and my philosophy is that I bought this as a joke and I'm going to hold on to it until it makes me a multimillionaire, because why not. But a lot of people buy and sell crypto pretty quickly taking that day-trading approach. Can you talk about crypto and how it fits into our discussion about risk and return?
Alana: Crypto is interesting because it is still a relatively new product. And when you talk about averages and trends for the stock market, we have a couple hundred years worth of data to pull from. And even in its short lifespan, crypto has had huge highs and very low lows. For instance, between 2020 and 2021, Bitcoin's U.S. dollar equivalent ranged from $5,000 or $6,000 to over $60,000. And at the time of this recording, it's hovering around almost $42,000. So, if you were trying to time that market with its super high highs and low lows, you could risk selling at the wrong time and potentially lose a good chunk of your investment.
Sean: And crypto is known for its volatility, but some folks might think that the highs make any risk worth it. What do you think about that?
Alana: I think it depends. The way you've done it, where you've taken a smaller amount of fun money and invested in crypto may be OK for some investors, as long as you feel comfortable losing all that money. In my opinion, I don't think putting all of your eggs into the cryptocurrency basket is a good call for most investors since it does have such a high level of risk. But just to couch that, that is my personal opinion and I am not a registered investment advisor. So, it depends on everyone's personal situation and circumstance.
Sean: I think it is fair to say that a bunch of cryptocurrency is not going to be a better option for most people's long-term investment strategy than a 401(k) or an IRA, for example.
Alana: And if people do have questions about that and are really excited about cryptocurrency, they can talk to a CFP or another financial advisor and be able to get some personalized financial information.
Sean: OK. Now I want to talk about one more thing that I think a lot of people are interested in right now in particular, which is sustainable investing. How do you think people can utilize sustainable investing? And are we going to be able to save the planet by investing in windmills?
Alana: Well, I really hope so, but I'm not sure if we're going to be able to fix everything. Sustainable investing has been a huge trend over the last couple of years. And it's all about using your investment dollars to create good in the world. And there are a lot of terms for this. There is socially responsible investing, ethical investing, you name it. The one that's different is ESG investing, which specifically refers to investing in companies with good environmental, social and corporate governance practices.
Sean: Hence where ESG comes from, got it.
Sean: Can you give us an example of an ESG investment?
Alana: There are a number of ESG funds that people can invest in, many of which have kind of clunky, awkward names, like the 1919 Socially Responsive Balanced A Fund or the Parnassus Core Equity Investor Fund — and we are not recommending either of these. But what these names don't really tell you is that they are funds that are focused on those environmental, social and governmental principles. There are lots of ESG funds out there now and they may have a lower carbon footprint and stricter sexual harassment policies for the companies that are in those funds, for instance.
Sustainable investing came under a lot of scrutiny for years because people weren't sure that they would perform as well as traditional funds. But in fact, there's been a lot of data that's come out in the last couple of years suggesting that not only can they match the performance of traditional funds, but they can sometimes outperform them as well.
Sean: Mm-hmm. And people also used to be kind of wary of these funds because they used to be more expensive too, right?
Alana: Yeah, that's correct. But now there are lots of ESG ETFs, those exchange-traded funds that we talked about last time, and those are a much cheaper alternative than actively managed ESG mutual funds.
Sean: OK. Well, I think that about covers it. We talked about a lot today, but we are not quite done. We have some nerdy homework for you, our listeners to complete. Alana, do you want to kick us off?
Alana: Yeah. So first, think about what kind of strategy you'd like to implement within your portfolio. Are you going to be buying and selling stocks on the regular or would you prefer to take the buy and hold strategy?
Sean: Next, explore some alternative investments like cryptocurrency or think about investing philosophies such as sustainable investing. Where could these principles fit into your investing practice?
Alana: Lastly, put it all together. You've learned so much about investing, now it's time to get started.
And that's it for this episode. For more information about how to get started investing, check out our show notes, posted at nerdwallet.com/podcast.
Sean: And before we go, here is our brief disclaimer, thoughtfully crafted by NerdWallet's legal team. Where your questions are answered by knowledgeable and talented financial writers, but we are not financial or investment advisors. This nerdy info is provided for general educational and entertainment purposes, and may not apply to your specific circumstances.
Alana: And until next time, turn to the Nerds.