‘I have never seen so much headline risk’: Trader on COVID-19 impact
The current mayhem on the markets is forcing many retail investors to come face-to-face with a basic question: Am I a trader or an investor?
Under normal circumstances, you could be a little of both, but a breakdown in fundamentals caused by the COVID-19 pandemic has made the difference stark. Both attempt to profit from financial markets, but traders generally seek short-term gains by actively participating in the markets. In contrast, investors are more likely to buy and hold position over the long-term. They are also more likely to sit this unprecedented crisis out.
Trading in this market is risky, which brings the potential for big gains or big losses. It generally requires more frequent trades, shorter holding periods, and a readiness to react to rapidly-changing market conditions.
Profits or losses for traders tend to be smaller but more frequent. They often employ a vast array of investment strategies such as technical analysis, and investment vehicles including options and exchange-traded funds (ETFs) that mimic commodity prices or take short positions that generate profits when prices fall.
To help hedge all that risk, traders will often pre-set conditions on their trades such as stop-loss orders that automatically sell if the price falls below a certain level.
In some cases, traders will establish margin accounts with their brokerages that allow them to borrow against equities they already own. Borrowing to invest is risky in the best of times, but in markets like these a rapid drop in the value of the underlying assets can prompt the lender to demand partial repayment of the loan known as a margin call.
The investor’s objective is to gradually build wealth over a long period of time. While profit is the overriding objective for the trader, preserving profit is the primary goal of the investor.
Investors will seek discounted shares in companies that will generate and grow profits over a long period of time. The most common tool to determine if a stock is discounted is the price-to-earnings ratio (PE), which compares earnings (profit) per share to the current share price. The price of all stocks reflects the market’s confidence in the company’s ability to grow profits.
Investors are more likely to sit this market out because that fundamental measure of a stock’s worth has broken down. As global economic activity comes to screeching halt, companies are having to toss their earnings projections aside and, in many cases, say they simply don’t know enough at the time to present alternative estimates.
The only thing left for investors to do is watch and learn. Well-managed companies with histories of earnings growth tend to fall less when markets are down and rise faster when they recover. If they already own a company based on strong fundamentals, and have cash on hand, it might be a good opportunity to buy more and wait for a recovery.
The greatest strength for an investor comes through the power of compounding by re-investing profits and dividends over time.
A more long-term view also provides the opportunity to hedge against risk before a crisis like this happens by diversifying their portfolio along sector and geographic lines, investment funds and fixed income.
TFSA is for traders, RRSP is for investors
Traders tend to invest for short-term goals while investors tend to invest for retirement. For Canadians, that also highlights the stark difference between tax-free savings accounts (TFSA) and registered retirement savings plans (RRSP).
From a tax perspective, a TFSA is better suited for a trader because funds can be withdrawn at any time tax-free. Allowable contribution space can be regained the following calendar year.
While RRSP contributions can be deducted from income when they are made (unlike a TFSA), those contributions and any gains they generate are fully taxed when withdrawn. That means contributions made in a higher tax bracket generate a bigger refund, grow tax free over a long period of time, and can potentially be withdrawn in a lower tax bracket in retirement.
Early RRSP withdrawals for anything other than a first-time home purchase or continuing education would likely wipe out the initial tax savings and the contributor loses their allowable contribution space for future years.
Of course, the investor has the option of using their TFSA for retirement savings as well.
Payback Time is a weekly column by personal finance columnist Dale Jackson about how to prepare your finances for retirement. Have a question you want answered? Email firstname.lastname@example.org.