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Outperform the market

All investors must choose the Best Stocks in the Best Sectors, re-evaluate and refine their investing styles and strategies from time to time. I have potential subscribers, frequently ask me "Can you consistently outperform the market?" As we gain investing experience and knowledge, our view of the market is likely to change and most likely broaden how we envision the extent of our investing capacity.

Those who want to try to outperform the market - that is, realize returns greater than the market average - might consider an active trading strategy, even if only for a portion of their portfolio. Here we explain what active trading is, how active traders view the market, their tools and investment vehicles and finally, the risks associated with their style.

What is active trading?

The best way to understand what is active trading is to differentiate it from buy-and-hold investing, which is based on the belief that a good investment will be profitable in the long term. This means ignoring day-to-day market fluctuations. Using a buy and hold strategy, this kind of investor is indiffenrent to the short-term for two reasons:
  1. First, because he or she believes any momentary effects of short-term movements really are minor compared to the long-term average, and
  2. Second, because short-term movements are nearly impossible to exactly predict.

An active trader, on the other hand, isn't keen on exposing his or her investments to the effect of short-term losses or missing the opportunity of short-term gains. It's not surprising then, that active traders see an average long-term return not as an insurmountable standard but as a run-of-the-mill expectation. To exceed the standard, or outperform the market, the trader realizes that he or she must look for the profit potential in the market's temporary trends, which means trying to perceive a trend as it begins and predict where it will go in the near future.

Remember that even though the security moves upward over time, it experiences many smaller trends in both directions along the way

Performance and the short term

Traders are 'active' because for them the importance of the market's short-term activity is magnified - these market movements offer opportunity for accelerated capital gains. A trader's style determines the time frame within which he or she looks for trends. Some look for trends within a span of a few months, some within a few weeks, and some within a few hours. Because a shorter period will see more definitive market movements, a trader analyzing a shorter time frame will be more active, executing more trades.

A greater number of trades doesn't necessarily equal greater profits. Outperform the market doesn't mean maximizing your activity, but maximizing your opportunities with a strategy. An active trader will strive to buy and sell (or vice versa in the case of shorting) at the two extremes of a trend within a given time frame. When buying a stock, a trader may try to buy it at the lowest point possible (or an upwards turning point, otherwise known as a bottom) and then sell it when there are signs that it has hit a high point. These signs are generally discerned by means of technical analysis tools, which we discuss below. The more the trader strives to buy and sell at the extremes, the more aggressive - and risky - is his or her strategy.

Maximizing returns or outperform the market isn't just about reaping profits, it's also about avoiding losses. In other words, the trader will keep an eye out for any signs that the security is about to take a surprising turn in an undesirable direction. When these signs occur, the trader knows that it is time to exit the investment and seek profits elsewhere. A long-term trader, on the other hand, stays invested in the security if he or she has confidence in its value, even though it may be experiencing a downward shift - the buy and hold investor must tolerate some losses that the trader believes are possible to avoid.

The risks

Active trading offers the enticing potential of above-average returns, but like almost anything else that's enticing, it cannot be achieved successfully without costs and risks.

The shorter time frame to which traders devote themselves offers a vast potential but, because the market can move fast, the trader must know how to read it and then react. Without skill in discerning signals and timing entries and exits, the trader may not only miss opportunities but also suffer the blow of rapid losses - especially if, as we explained above, the trader is riding on high leverage. Thus, learning to trade is both time consuming and expensive. Any person thinking of becoming an active trader should take this into account.

Also the higher frequency of transactions of active trading doesn't come for free: brokerage commissions are placed on every trade and, since these commissions are an expense, they eat into the trader's return. Because every trade costs money, a trader must be confident in his or her decision: to achieve profits, the return of a trade must be well above the commission. If a trader is not sure of what he or she is doing and ends up trading more frequently because of blunders, the brokerage costs will add up on top of any losses.

Finally, because securities are being entered and exited so often, the active trader will have to pay taxes on any capital gains realized every year. This could differ from a more passive investor who holds investments for numerous years and does not pay capital gains tax on a yearly basis. Capital gains tax expense must also be factored in when an active trader is calculating overall return.

Stock market for beginners

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