Quite recently, Charles Schwab (an e-broker) announced that they would no longer be charging commissions on stock trades. Shortly thereafter, TD Ameritrade, E*TRADE, Interactive Brokers, and Fidelity Investments all followed suit. A financial technology (fintech) firm, Robinhood already offered commission-free trading. So essentially, anywhere you open up a brokerage account to trade stocks, you will not have to pay any commissions. The question is…….should you start trading stocks?
The aforementioned question is difficult to answer in relation to all the types of people that are reading this article. However, whether or not you decide to trade stocks, I simply want to ensure that you are using the proper benchmark to gauge your success in terms of the performance returns you achieve. Now I am assuming that, since you are trading stocks, the assets are held in a taxable brokerage account. Furthermore, an active trader is likely to have a holding period for those stocks that is less than 365 days. Therefore, the gains are fully taxable as ordinary income. With that groundwork laid, let’s move on to a further analysis.
Trading stocks and “beating the stock market” is an extraordinarily difficult task to do. Most of the professional asset managers fail to beat their respective benchmarks for performance returns. Additionally, trading stocks in the short term requires two things: gauging market sentiment correctly and the valuation of the stock based upon its fundamentals. You have to be right on both accounts. There are many times when a company has a ton of good announcements that should cause the stock price to increase, but other factors hinder the upward movement in the stock price. Examples include: negative sentiment about the stock market in general, negative sentiment about the industry the company is in, geopolitical uncertainty, poor economic data, central bank (Federal Reserve) policy, and many others. The bottom line is that you can be exactly correct on positive news for the stock you are buying, but, if there are negative overhangs in the stock market for any reason, the stock price may not go up.
Another word of caution is just to identify what it means to trade stocks in the short term. Trading stocks in the short term is speculation, plain and simple. Short-term trading is not investing at all. There are myriad reasons why, but I will not address that in this article. Just know that you are a trader who is speculating on stocks and market sentiment related to the stocks you choose to trade. Any holding period of a stock less than one year does not meet the bar of what investing means. As long as you know that going in, that is fine and I will not dissuade you in any way from trading.
The important thing to remember is that you need to gauge your performance in relation to the overall stock market based upon after-tax returns and not gross returns. Why? At the end of the day, you only care about the terminal value of the asset in your brokerage account. What do I mean by terminal value? Terminal value just means the amount of money you have after paying capital gains taxes as ordinary income. For example, if you have a 10% return in your stocks and the S&P 500 Index is only up 8%, you need to look at your taxes too. Just for illustrative purposes, let’s assume that your marginal rate for federal and state taxes is 25%. If we go back to the 10% amount, you will have a 7.5% (10% – 10% * 25%) after-tax gain from trading. Yes, you beat the stock market return on a gross basis, but you end up with 0.5% less after all is said and done.
I am going to use the historical returns of the S&P 500 Index from 1957 to 2018 as the benchmark that you should be referencing when examining your success (or failure) as a result of trading. As I have mentioned in many prior articles, I use 1957 as the starting year because the S&P 500 Index was created in that year. Prior to 1957, the S&P Index had less constituents so going back in history further than that year does not yield an apples-to-apples comparison. The long-term historical return of the S&P 500 Index over that period was approximately 9.8%. Therefore, I will use that historical return to reference the gross return versus after-tax return issues.
Here is a table to look at the performance return you need to equal just to be even with the S&P 500 Index after taxes:
As you can see, the gross return equivalents in relation to the historical return of the S&P 500 Index range from 12.3% to 16.3% for the various marginal tax rates shown. For instance, if you are in the 30% marginal tax bracket for federal and state income tax purposes, you will need to earn 14.0% returns just to break even. Most people add or remove monies to their brokerage accounts over the course of any given year, so you need to adjust for those cash flows. The computations are a little trickier and beyond the scope of this discussion.
Another important thing to take into account is the types of stocks you purchase. The stocks included in the S&P 500 Index are very large companies by market capitalization (large caps). Market capitalization is simply the number of shares outstanding times the stock price. If you invest in very small stocks that you deem to be good trading opportunities, you should not be using the S&P 500 Index table above to do your calculations for after-tax returns. For example, if you tend to invest in smaller companies, you would want to use the Russell 2000 Index or the S&P 600 Index. For any companies below $1 billion in market capitalization, you should seek out what are called microcap indexes. The best way to build your personal table is to use a “blended benchmark” for performance returns. A “blended benchmark” is what large institutions and high net worth individuals use, and it is the gold standard because you are truly comparing apples-to-apples.
If you want to learn more about how to create your personal “blended benchmark”, I addressed that topic five years or so ago and here is the link to that article:
In summary, if you decide to trade individual stocks because commissions are zero now or you have always done so in the past, you need to compare your after-tax return to what you would have earned if you had simply bought the S&P 500 Index via an index mutual fund or an Exchange Traded Fund (ETF). Why? Those performance returns would be available to you if you simply invested in one. Note that the fees on index mutual funds and ETFs are extremely low (0.05% or less and in some cases like Fidelity Investments are free). You always want to select your next best alternative to measure whether or not you are earning more than the stock market on an after-tax basis. Remember that all you really care about at the end of the day is how much money you have leftover in your brokerage account minus what you pay in federal and state income taxes.