Swing trading is a broad term that includes a variety of short-term trading strategies in the stock market. The Internet, online trading platforms, and the information revolution have made swing trading strategies increasingly accessible to the individual investor over the past several years.
However, just because swing trading is now easier to implement, that doesn't make it the best course of action. In fact, the evidence indicates that swing trading can materially hurt your returns.
What is swing trading?Swing traders typically invest in a stock or an ETF, or exchange-traded fund, for relatively short periods. Swing trading positions are held for more than a single day, but rarely longer than three or four weeks. This makes swing trading intrinsically different from long-term buy-and-hold investing, where investors can commit to a specific investment for years or even decades.
Swing trading strategies come in different flavors. Many swing traders rely on graph patterns and technical analysis to make trading decisions. Even among those who use similar tools, the strategies can vary substantially.
Many swing traders use mean-reversion techniques, meaning they intend to buy at low prices and wait for a change in direction to sell at higher levels. On the other side of the spectrum, some traders look for stock prices that are going up strongly. The main idea is that winning stocks tend to keep on winning, so they intend to buy at high prices and sell at even higher levels.
Swing traders can also incorporate fundamental factors into their decisions. For example, many swing traders make short-term bets on a company about to release earnings. The main idea is to profit from buying shares of companies that will do better than Wall Street expects and selling the names that are about to underperform expectations in their earnings reports.
Even more sophisticated, other swing trading strategies are based on macroeconomic variables. Traders may believe that a particular economic indicator will be above or below forecasts and then take a position in the market to capitalize on that possibility. In these cases, the trader needs to be right on both how economic variables will perform and the way in which this will affect a specific asset.
Is swing trading right for you?Depending on your own style and personality, swing trading can sound exciting, or perhaps too complex and demanding. Nevertheless, the evidence indicates that trading too actively can be major drag on performance over time. According to different studies, short-term traders generally achieve materially lower returns than long-term buy-and-hold investors.
A famous statistical study from Brad Barber and Terrance Odean from the Graduate School of Management at the University of California has a clear and powerful headline: "Trading Is Hazardous to Your Wealth."
The authors analyzed the returns of 66,465 households with accounts at a large discount broker from 1991 to 1996. According to their findings, those that traded more frequently earned an annual return of 11.4% over that period, while the average account made 16.4% annually.
To put the numbers in perspective, an investor with a $100,000 portfolio earning active-trading returns of 11.4% over six years would end up with an account value of $191,122. The average investor, on the other hand, would finish that period with a much bigger portfolio value of $248,724. Over the period under analysis, active trading would have reduced the value of your capital by 30% in comparison with the average investor. For longer periods, active trading can be even more expensive.
Fidelity Investments once analyzed the returns of different investors with accounts at the firm, and the results were staggering: Those who forgot they even had an account at Fidelity did best.
The idea is simple, and the statistical evidence clear: Chances are, the more actively you trade, the lower your returns will be over the years.
Investing in solid high-quality companies for the long term is a far sounder investment strategy than trying to predict market turns in the short term. You don't need to take my word for it. Warren Buffett is arguably the most successful investor ever, and he's all about long-term focus and patience. In his own words, "Lethargy bordering on sloth remains the cornerstone of our investment style."
How swing trading can hurt your returnsEvery time someone is buying, someone else is selling. That means short-term trading is a zero-sum game: if someone is going to outperform the market, someone else needs to underperform.
If you're trying to outperform the market via short-term trading, then you need to compete against trading professionals with almost unlimited resources. This includes teams of experts supported by massive computing power and access to enormous amounts of information available to them at the speed of light. Chances are not on the side of the individual investor in this competition.
Even worse, swing trading means much higher costs from trading commissions and taxes. The impact from higher taxes is a crucial factor that many short-term traders typically overlook, and it can have huge negative implications on your returns.
When you hold your investments for more than a year, the gains are subject to long-term capital gains taxes, which are remarkably favorable in comparison with short-term trading gains. Short-term gains are taxed at your ordinary income tax rate, which goes from 10% to as high as 39.6%.
On the other hand, tax rates on long-term capital gains are zero for investors in the 10% to 15% income tax brackets. For taxpayers in the brackets between 25% and 35%, long-term capital gains are only 15%. Those in the 39.6% tax bracket still get a big discount, as they pay long-term capital gain taxes of 20%.
When trying to outperform the market in the short term, you're competing for the same piece of the pie against trading firms and professionals with far more resources than you. Even worse, the overall pie gets smaller once you factor in variables such taxes and trading costs. With this in mind, it's really no wonder most investors suffer a big decline in their returns when they engage in swing trading and other kinds of short-term strategies.
Time in the market beats timing the marketIt takes consistency and discipline to keep a long-term investing focus in times of information overflow. Many brokers tend to encourage active trading among their clients, providing all kinds of advice and recommendations as to when and why they should make a particular trade.
Remember that brokers make money every time you make a transaction, so advice coming from these companies can be biased against your best interests.
Something similar happens with many media outlets. Headlines creating panic or greed among readers typically attract lots of attention. You can sell more magazines or generate more online clicks when you tell your readers they need to take immediate action, buying or selling a particular asset as soon as possible. However, the evidence proves that what's best for news companies or Wall Street brokers is generally not the best for your own wealth.
A stock is simply an ownership share of a business. In the short term, stock prices fluctuate because of a multiplicity of unpredictable factors, including not only economic variables but also investor sentiment and market speculation. On a long-term basis, however, if the business does well, so will the stock.
Instead of trying to outsmart the market in the short term, you may want to consider investing in the best companies for the long term, as this can be a simple and powerful strategy to achieve superior returns with lower risk over time.
In the words of Warren Buffett himself: "If you aren't willing to own a stock for 10 years, don't even think about owning it for 10 minutes. Put together a portfolio of companies whose aggregate earnings march upward over the years, and so also will the portfolio's market value."
The article Is Swing Trading the Best Strategy for You? originally appeared on Fool.com.
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