It seems like the stock market has taken over the news lately (ex. GameStop), as individuals have more access than ever through various brokerage platforms and the pandemic significantly increased the popularity of actively trading stocks. Both trading and investing have their benefits and risks, however, it is important to understand the differences between the two strategies (with the major disparity being time) before you take action.
Trading involves short-term buying and sell of stocks and other financial assets with the goal of making a quick profit. This time period can be months, days, or even minutes. The goal is to earn higher returns than holding an asset for the long-term. It can be thrilling to trade, but should only be done with money you can stand to lose, just like gambling at a casino, as this can be very risky. If you choose to trade, start small and make sure you are funding your other financial goals first.
On the other hand, investing is gradually building wealth for the long-term. This can be composed of many different strategies and types of accounts, but overall, you are putting money in the market with the goal of long-term growth. Most often, you will buy a stock, mutual fund, exchange-traded fund, or other investment with the plan to hold it for an extended period of time, often with the goal of funding your retirement. The market may fluctuate in the short-term, but that should not change your strategy, as you are investing for years or decades ahead. Diversification, a.k.a. holding a wide variety of investments within your portfolio, will reduce your overall risk to combat these market fluctuations.
There are several different account types available with different tax implications. In a taxable brokerage account, which is most commonly used for trading, you pay taxes on positions when they are sold, and the amount of tax depends on how long you’ve held the position. If you sell an asset with a gain (more than you purchased it for) that you’ve held for less than a year, the gain will be taxed as ordinary income. If you’ve held the position for over a year, you will be taxed at a long-term capital gains rate, which is currently either 0%, 15%, or 20%.
You may be better off starting to invest in a tax-advantaged account, such as an IRA or Roth IRA, which do not have tax consequences when trades are placed within the account. With a traditional IRA, you contribute pre- or after-tax dollars and withdrawals are taxed as income after reaching age 59 ½. With a Roth IRA, you contribute after-tax dollars and can normally make tax-free withdrawals after age 59 ½. Keep in mind, there generally is a 10% penalty for taking money out of these accounts before you reach age 59 ½.
If you are offered a workplace retirement plan, do not invest anywhere else until you are at least getting your full employer match, as that is essentially “free money.” Many people do not open a taxable brokerage account until they are maxing out their workplace retirement plan and/or IRA or Roth IRA to take advantage of tax-deferred growth. If you are maxing out your retirement account(s), a taxable account is a great way to invest additional funds with money you can withdraw at any time.
As we know, the media does a great job creating excitement and fear, so it is important to keep your investment strategy aligned with your goals, not emotions. Always keep your risk tolerance and time horizon in mind when selecting a strategy. Create a plan, only speculatively trade stocks with money that you can afford to lose, and make sure you understand the tax implications of your decisions ahead of time. If you need guidance, seek out a financial planner, who can help you determine your investment strategy and develop a plan to execute it.