One of the unintended consequences of COVID-19 and the stimulus packages has been the influx of excess cash into the stock market. 2020 saw the largest number of new non-retirement brokerage accounts opened in the past several years. For many of these new investors with excess cash, they were younger (under age 45) and had lower incomes. This also was the first opportunity they had to invest, and many resorted to learning about investing through social media.
Of course, there are many content producers on Instagram, TikTok, Facebook, YouTube, and Reddit that provide a grade-school level financial education. For example, wallstreetbets, an investing discussion forum on Reddit, recently led to a large influx of cash into the stock market, directed at GameStop. As a result, many investors were left with significant gains and a taste for investing.
For tax professionals, there are two points of advice that should be relayed to these clients: the tax consequences and potential bad investor habits.
Tax consequences
There are two types of capital gains: short-term and long-term gains. Short-term gains are for investments held less than one year and are taxed as ordinary income tax rates, similar to earned income.
Long-term gains are for investments held longer than one year and are taxed at specified rates of either 0%, 15%, or 20%, with the determining factors being filing status and income. Most of these new investors will end up either having short-term gains by cashing out and not realizing the benefit of long-term capital gains, or because they are investing in short-term securities such as options.
Depending on the income level of the investors, there are pluses and minuses to the tax rate configuration. For example, for married couples who are making slightly over $80,000, the 12% ordinary tax rate is actually better for this group. There are many online calculators that will help with advising on the best tax scenario.
Reminding and educating the client of the tax consequences related to short- or long-term investing will help to ensure they don’t go and spend all of their proceeds. A common bad habit for even seasoned investors is forgetting to save or make an estimated tax payment for the taxes generated by selling an investment.
Potential bad investor habits
The larger concern for inexperienced investors is the potential bad habits that are born from this style of investing. Many of these new investors – while eager to learn – are often shortsighted and are getting their information from unqualified individuals. Many of these content producers tend to not provide sound financial information and disclaim that they are not providing financial advice to cover themselves legally.
Nevertheless, some producers have large followings, and ill-informed people act on rumors and misinformation, rather than the actual financial results of the underlying investment. Historically, as information shifts and they are unaware, it has ended poorly for this type of investor, leaving them with significant losses.
Another bad habit for those who do well initially is that they begin to believe that the trend will continue indefinitely, and they then make riskier investment decisions and/or begin trading in options without fully understanding how these types of securities work. These bad habits often lead to the irrational exuberance theory, where “bubbles” are created. Investors begin to hear rumors about an investment and flood the market, creating a bubble. However, the underlying investment doesn’t support the enthusiasm, or one bit of bad news pops the bubble and panic selling takes place.
This often leads investors to sell too early to take full advantage of the market moving upward, causing them to lose gains, or buy too late and end up on the downward side of the investment with a loss. Unfortunately, far too often, these actions will deter some investors from continuing to learn, and take advantage of, sound investment opportunities in the future, fearing this cycle. They tend to end up relying on very conservative investments with lower returns.
How do you, as the trusted advisor, correct some of these habits?
- Point out that relying on historical data shouldn’t be the only factor in making
- Instead of simply relying on social media, help educate and point your new investor clients to solid resources with good reputations, such as Investopedia, Intuit’s mintlife blog, or whatever sources you believe are reputable.
- Remind them that investing is zero-sum; there will be gains, but there will always be losses.
- Suggest setting investment goals or boundaries per investment: “I will sell xxx when I reach a 20% gain, or a 5% loss.” This way, you are always on target with your investment objective.
- Suggest setting an investment objective: “Why are you investing?”
Personally, I advise telling the short-term investor that you are essentially gambling, looking at micro variations, and betting that the market will go in the direction that you are investing. Conversely, the long-term investor tends to be more macro, looking at the overall economy and stability. Historically, there is no indication that the long-term investor does better than a short-term investor. However, the work needed for consistent positive results for a short-term investor is significantly more than for the long-term investor.
COVID-19 resulted in people having more time to do research on investments, and that might be fruitful in the short term. I hope these new investors continue to become more educated and invest wisely. With your help, becoming more financially literate contributes to the success of our economy and ultimately leads to a golden lining.
One last note: If you are not comfortable with providing financial or investment advice, don’t do it. Consider reading my article, “How adding financial planning can turn a seasonal tax practice into a year-round business,” or find a local professional to partner with and trade referrals. You can also search for “tax and financial planning” professionals on Find-a-ProAdvisor, and check out the CFP Board for more information.
