Investing is a key part of planning for your financial future, but there are many ways to go about it. Some people manage their investments themselves, choosing and implementing their own investment strategy. Is self-directed investing right for you?
Let’s look at the pros and cons.
What Is Self-Directed Investing?
Self-directed investing is managing your investments yourself. Rather than working with a financial professional or building a simple portfolio based on a few mutual funds or ETFs, self-directed investors evaluate and choose the stocks, bonds, and other securities that make up their portfolios.
What Draws People to Self-Directed Investing?
Self-directed investing first took off during the dot-com boom in the late 90s, when online trading platforms became widely available. The trend faded after many self-directed investors took serious losses in the subsequent bust.
Self-directed investing has seen a resurgence in recent years. The availability of mobile-focused, commission-free brokerages that make it easy to buy and sell stocks has drawn more people to the world of finance and investing.
Online communities have also played a big role. People gather in these communities to discuss their trades and investments. Often, people emphasize their wins and downplay their losses, which can help give people the impression that self-directed investing is an easy way to make money.
Active investors often achieve high status within these communities, pushing more people to try their hand at self-directed investing.
Pros of Self-Directed Investing
Self-directed investing is popular for a reason. These are a few of the advantages of actively managing your portfolio.
Potential for Higher Returns
Perhaps the biggest advantage of self-directed investing is the potential to earn a higher return than the market as a whole. Many high-profile investors have earned billions by carefully managing investment portfolios and beating the market on a consistent basis.
Active investors can beat the market in some situations. This is especially true during bull markets, where big-name companies tend to outperform. For example, as of July 28th, 2023, Nvidia has seen a year-to-date increase of roughly 225%. The S&P 500, by contrast, has only gained about 19.7%.
A self-directed investor who took the plunge and loaded up on Nvidia shares based on AI and other tech news could have massively outperformed more passive investors.
More Choice and Flexibility
Active investors tend to have more flexibility when building a portfolio and making trades than passive investors. Those who take a less active role in managing their portfolio usually rely on buy-and-hold investments. That means holding shares through both up and down markets. They might rebalance based on market movements, but that’s about all they’ll do.
Self-directed investors can use different types of securities to make more complex trades and execute more advanced strategies.
Options are one of the most common ways for self-directed investors to do this. For example, an investor who feels like the market or a specific share is about to drop could buy put options. This gives them a way to generate a profit even in a down market.
More complicated options transactions allow for the generation of cash flow or profit in different scenarios. Options also let active investor leverage their portfolios, augmenting their gains but also their losses.
Fun
For many people, investing isn’t just a way to build wealth, though that is a major appeal. Investing can also be fun.
Researching the market and different companies can be entertaining, and keeping an eye on your portfolio is fun. It feels good to feel successful when an investment you make pays off.
For people who find finance fun, active investing is very appealing.
Cons of Self-Directed Investing
Though self-directed investing can be appealing and has its benefits, you also have to think about the drawbacks.
It Takes Time
One of the top drawbacks of self-directed investing is the amount of time it takes.
A passive investor usually spends a bit of time settling on their desired asset allocation and then uses mutual funds to help reach that asset allocation. Passive investors might spend some time every few months to rebalance their portfolio, but the time investment is minimal.
Self-directed investors spend far more time focusing on their money. How much time exactly depends on the investor.
People who try their hand at day trading could spend hours every day managing their portfolio, buying and selling securities to try and earn a strong return. Even those who don’t make daily trades likely spend hours every week researching the market and different investment opportunities.
The time spent on active investing has to be considered when looking at overall returns. If you can earn an extra 1% return but spend 10 hours a week to do it, is that worth the time spent?
Likelihood of Lower Returns
Though self-directed investors could earn more than the market, the opposite is far more likely.
It’s incredibly hard to beat the market on a consistent basis. While some people have built a reputation as great investors who can beat the market regularly, those people are few and far between.
Fewer than 10% of actively managed mutual funds beat the market on a consistent basis. These funds are managed by teams of highly experienced professionals who know the finance industry and the area of focus for their funds, inside and out.
If not even one out of every ten Wall Street pros can do it regularly, it’s easy to see how even an enthusiast who spends a lot of time managing their portfolio could struggle to beat the market and is more likely to produce worse returns than someone who uses a more passive strategy.
This is by no means the rule. There are exceptions. However, the odds are stacked against you, and you’re far more likely to underperform than overperform.
The Risk of Irrational Behavior
Everybody thinks that they are disciplined and in full control of their actions and decisions. It’s not always true, especially in the high-pressure crucible of the stock market. Many self-directed investors fail, even those that initially succeed, because they lose control and make bad decisions.
This irrational behavior can arrive in multiple ways.
- Overuse of debt. Many self-directed investors start playing with borrowed money, especially when they are on a roll and doing well. This adds a whole new layer of risk to the already risky investing game.
- Emotional attachment. It’s easy for investors to get attached to investments that they studied and chose. That can lead them to overconcentrate on one investment or hold onto it far too long, often with dire consequences.
- Addiction. Some self-directed investors begin to exhibit addictive behavior, trading constantly, neglecting other parts of their lives and plowing more and more money into trading.
It’s important for self-directed investors to be confident in their ability to maintain a rational investment strategy and continuously monitor their own behavior. These risks are real and have derailed many self-directed investors.
Taxes
Active investors are likely to pay more taxes than passive investors. This is due to how capital gains taxes work.
When you sell an investment for a profit, you must pay taxes on the profit you’ve generated. If you’ve owned the security for less than a full year, you must pay short-term capital gains taxes. If you’ve held the security for more than a year, you pay long-term capital gains.
The short-term capital gains rate is equal to your regular income tax rate, meaning it could be as high as 37%. The long-term capital gains rate is lower, with those in the first three tax brackets (earning up to $95,375 as a single filer in 2023) paying 0%. Most others pay 15%, but those in the top tax bracket pay 20%.
Self-directed investors are more likely to sell winning stocks within a year of buying them, triggering short-term capital gains taxes. They’re also more likely to sell shares in general. Passive investors may hold shares for many years before selling them, which lets them delay their tax liability.
Which Should You Choose?
For the vast majority of people, the better choice is likely to use a passive investing strategy. Consider your goals and risk tolerance, then build a portfolio using low-cost index funds that create a portfolio with your desired asset allocation.
With occasional rebalancing, you can achieve reliable long-term returns without having to put in too much effort.
It is incredibly difficult to succeed at self-directed investing. If you have extensive knowledge of a specific industry or pay incredibly close attention to news covering certain topics, that may help give you some edge, but it can still be hard to outperform the market. Even investors who have a successful run often end up losing most or all of what they have gained.
Even if you do have that highly specialized knowledge, it’s key to diversify your portfolio to avoid catastrophic losses.
If you’re thinking about trying your hand at self-directed investing, consider a middle ground. Dedicate most of your money to a safe, diversified, passive investment portfolio. Then, you can use a small portion of your money for self-directed investing.
If you put 95% of your money into safer, passive investments, you can use the remaining 5% to try active investing without much risk. This lets you gain experience and have fun by trying to beat the market without risking your long-term financial stability. If you do manage to outperform, you can accelerate your portfolio’s growth and consider dedicating more funds to active investing.
Final Word on Self-Directed Investing
Passive investing that aims to track the market rather than beat it is the safe choice and the better solution for most people. Self-directed investing can be fun but takes a lot of time, and even the vast majority of professionals fail to beat (or even keep pace with) overall market returns consistently.
Whichever strategy you use, be sure to build a diversified portfolio that matches your risk tolerance and understand that investing is subject to risk. Avoid investing money that you cannot afford to lose.
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