Online trading may look like a fairly quick and convenient way to build wealth, but there are many hidden dangers that may not be evident at first.

The main risk comes from the fact that it all may seem deceptively easy. The lower costs and higher speeds of online trading can lead otherwise conservative investors to trade too frequently. That can lead you to sell your best picks when they are just getting started.

The apparent ease of online trading may even prompt conservative investors to take up short-term trading or day trading. That’s just another danger of trading stocks online—there’s a large random element in short-term stock-price fluctuations that you just can’t get away from.

Trading stocks online: Lower costs are attractive, but investment quality makes money

This random element can be profitable for short periods. But you can’t reliably profit from it over the long term. In fact, most short-term traders wind up losing money. By the time their beginners’ luck fades, many are trading in dangerously large quantities.

Frequent trading can also lead you to buy lower-quality, thinly traded stocks. The danger arises from the fact that the bid and ask spreads of many of these investments can be so wide that the share price will have to go up significantly before you’ll even begin to make money on a sale.

You can make trades quickly in online trading, and that cuts your commission costs. However, for successful investors, this is a bonus, not the object of trading stocks.
It is far more important to focus on high-quality, well-established companies and how they fit in your portfolio. The longer you hold these stocks, the greater the chance that your profits will improve, as well.

Here are two other dangers to avoid in online trading. Both can seriously hurt your long-term returns:

1. Practice accounts can breed false confidence: Some investors are nervous about trading stocks online. So, instead of jumping right in, they start off by using the “practice accounts” or “demo accounts” that the online brokerage industry initiated several years ago.
   
   Practice accounts are supposed to be identical to real accounts in all but one respect: you buy stocks in them with imaginary or “play” money, rather than the real thing. The brokerage industry says this gives would-be traders a free opportunity to learn how to trade online without risking any money.
   
   Using an online broker’s practice account, you can learn online trading essentials, such as how to enter an order to sell or buy stocks; how to double-check your order before submitting it, so you avoid obvious but common mistakes, like buying 10,000 shares when you only meant to buy 1,000; and so on.
   
   The big risk with practice accounts is that you’ll try out a risky and ultimately unwinnable investment approach, like day trading or options trading, and hit a lucky streak. This could embolden you to put serious money at risk just when your results are about to regress to the mean. This will deliver losses instead of profits.

For a limited time only, sign up to get Pat McKeough's specific answers to your personal investment questions. Pat's proven expertise is available to guide the investment decisions of only a few new Inner Circle members. Click here to learn more about how you can benefit from membership in Pat McKeough's Inner Circle.

2. Automated stock-picking systems can backfire: Some investors who trade stocks online use automated stock-picking systems to help them make investment decisions. These systems are typically marketed with impressive-looking performance records designed to make investors think they are sure to make guaranteed profits.
   
   However, those records are typically derived by “back-testing” the program against past data. In other words, the promoters go back through old trading records and see what would have worked in the past.
   
   Automated stock-picking systems essentially do two things: First, they narrow down the data you use when you make investment decisions. Second, they apply a fixed rule, or rules, to draw a conclusion or an investment decision from that selection of data.
   
   Unfortunately, the market’s key concerns continually change. Today’s good investments can turn into tomorrow’s dead ends.
   
   For a time, these systems seem to work, but that’s usually coincidental. If the market is going up and the system tells you to buy volatile investments, it automatically generates profitable trades. But they can just as quickly turn around and begin pumping out unprofitable trades. Often this happens just when they can do the most damage to the investor relying on the system.

If you’d like me to personally apply my time-tested approach to your investments, you should consider becoming a client of my Successful Investor Wealth Management service. Click here to learn more.

Today’s tip: “Stock market software is a help, but successful investing calls for experienced human judgment.”

Many investment firms manage money with the help of something called a “black box.” This is stock market software that picks stocks or makes other investment decisions, based on historical data. Individuals sometimes buy these programs over the Internet or from direct-mail advertising.

Typical black-box sales pitch:

• Based on decades of research.
• System makes investment decisions automatically — eliminates human emotion and error.
• Great track record. A standard marketing claim reads like this: “Well, simple and to the point: if you back-test a robot and it shows 100% ‘demo’ profit in one month, it should PRODUCE around 80-100% profit in LIVE trading. That’s it … no more and no less!”

For a limited time only, sign up to get Pat McKeough's specific answers to your personal investment questions. Pat's proven expertise is available to guide the investment decisions of only a few new Inner Circle members. Click here to learn more about how you can benefit from membership in Pat McKeough's Inner Circle.

The reality:

Automated systems that make trading decisions for you do two laborious but essentially simple things. First, they narrow down the data you use to make investment decisions. Second, they apply some fixed rule or rules to draw a conclusion or an investment decision from that selection of data.

It’s easy to create stock market software that would have made profitable investments in the past. That’s because the programmer has all the data for the period, and can try various combinations of buying and selling rules to see if they would have worked.

However, markets are constantly changing. A rule that worked last year may fail miserably this year. Your black box has to compete against other black boxes created this year that also benefit from the latest software and up-to-date market data.

These systems often seem to work for a time, but that’s usually coincidental. If the market is going up and they tell you to buy volatile investments, they may generate a series of profitable trades. Then they quit working, and begin pumping out unprofitable trades. Often this happens just when they can do the most damage to their users.

Our investment advice: Be realistic. Stock market software that costs a few hundred dollars won’t make your fortune. The big profits in black boxes go to those who create and sell them to the public, not to those who buy and use them.

Next Wednesday, September 22, 2010, Investor Toolkit will look at the role of dividend paying stocks in your investment portfolio.

If you buy aggressive stocks, you really should have a subscription to Stock Pickers Digest. The latest issue gives you our full analysis, including clear buy/sell/hold advice, on 19 stocks that may be suitable for the part of your portfolio you devote to aggressive investing. What’s more, you can get this issue free. Click here to learn how.

Trading too frequently: The main risk is that the lower costs and higher speeds of online stock investing can quickly lead otherwise conservative investors to trade too frequently. That can lead you to sell your best picks when they are just getting started.

Trading stocks online may even prompt conservative investors to take up short-term trading or day trading. That’s just another danger of trading stocks online, because there’s a large random element in short-term stock-price fluctuations that you just can’t get away from.

Online trading cuts costs — but investment quality makes profits

This random element can be profitable for short periods. But you can’t reliably profit from it over the long term. That’s why most short-term traders wind up losing money. By the time their beginners’ luck fades, many are trading in dangerously large quantities.

Frequent trading can also lead you to buy lower-quality, thinly traded stocks. The danger here is that the bid and ask spreads of many of these investments can be so wide that the share price will have to go up significantly before you’ll even begin to make money on a sale.

Online stock investing lets you make trades quickly, and cuts your commission costs. However, for successful investors, this is more of a bonus. It is far more important to focus on high-quality, well-established companies, like the stocks we recommend in our Successful Investor newsletter, and how they fit in your portfolio. The longer you hold these stocks, the greater the chance that your profits will improve, as well.

Here are two other dangers to avoid when online stock investing. Both can seriously hurt your long-term returns:

Practice accounts can tempt you to take on too much risk: Some investors are nervous about trading stocks online. So, instead of jumping right in, they start off by using the “practice accounts” that the online brokerage industry recently began offering.

For a limited time only, sign up to get Pat McKeough's specific answers to your personal investment questions. Pat's proven expertise is available to guide the investment decisions of only a few new Inner Circle members. Click here to learn more about how you can benefit from membership in Pat McKeough's Inner Circle.

Practice accounts are supposed to be identical to real accounts in all but one respect: you buy stocks in them with imaginary or “play” money, rather than the real thing. The brokerage industry says this gives would-be traders a free opportunity to learn how to trade online without risking any money.

Using an online broker’s practice account, you can learn online trading essentials, such as how to enter an order to sell or buy stocks; how to double-check your order before submitting it, so you avoid obvious but common mistakes, like buying 10,000 shares when you only meant to buy 1,000; and so on.

The big risk with practice accounts is that you’ll try out a risky and ultimately unwinnable investment approach, like day trading or options trading, and hit a lucky streak. This could embolden you to put serious money at risk just when your results are about to regress to the mean and deliver losses instead of profits.

Automated stock-picking systems can backfire: Some investors who trade stocks online use automated stock-picking systems to help them make investment decisions. These systems are typically marketed with impressive-looking performance records designed to make investors think they have strong track records.

However, those records are typically derived by “back-testing” the program against past data. In other words, the promoters go back through old trading records and see what would have worked in the past.

Automated stock-picking systems essentially do two things: First, they narrow down the data you use when you make investment decisions. Second, they apply a fixed rule, or rules, to draw a conclusion or an investment decision from that selection of data.

The trouble is that the market’s key concerns continually change. Today’s good investments can turn into tomorrow’s dead ends.

For a time, these systems seem to work, but that’s usually coincidental. If the market is going up and they tell you to buy volatile investments, then they automatically generate profitable trades. Then they quit working, and begin pumping out unprofitable trades. Often this happens just when they can do the most damage to their users.

You can get our latest updates on issues that affect your investments, plus buy/sell/hold advice on stocks you may be considering buying (or selling) in our Successful Investor newsletter. Click here to learn how you can get one month free when you subscribe today.

Practice accounts are supposed to be identical to real accounts in all but one respect: you buy stocks online in them with imaginary or “play” money, rather than the real thing. The industry says this gives would-be traders a free opportunity to learn how to trade online without risking any money.

To us, this appears to be a misstatement — an example of the essence of marketing, which is to describe a feature in such a way that the prospect comes to see it as a benefit.

Using practice accounts to buy stocks online can distract you from a long-term investment strategy

Practice-account users aren’t learning how to invest. They are just learning how to enter orders to buy stocks online. Rather than an educational experience, practice accounts are a little like play-money sessions at Las Vegas, where gambling novices can learn to play casino games without risking any real cash.

For a limited time only, sign up to get Pat McKeough's specific answers to your personal investment questions. Pat's proven expertise is available to guide the investment decisions of only a few new Inner Circle members. Click here to learn more about how you can benefit from membership in Pat McKeough's Inner Circle.

In the casino, players are learning how to play the game. But they aren’t learning how to win, because that’s not possible. In the end, they can’t overcome the statistical advantage built into casino games that gives the house an edge. They’re really learning how to avoid losing their money any quicker than they choose to.

Using an online broker’s practice account, you can learn online trading essentials, such as how to enter an order to sell or buy stocks online; how to double-check your order before submitting it, so you avoid obvious but common mistakes, like buying 10,000 shares when you only meant to buy 1,000; and so on. In doing so, you can choose what stocks to buy, but the only feedback you’ll get on your choices is the price changes they go through after you buy.

However, there is a large random element in short-term stock market results. It will take months or years before you know if your choices are likely to provide attractive long-term returns. In fact, the real test will come only when you see how you do in the next bear market.

Practice accounts encourage behaviour that benefits brokers

Public-relations efforts on practice accounts often refer to them as good places to learn about day trading and options trading, which are big money earners for online brokers. Most non-professionals who get involved with day trading or options trading wind up losing money if they stick with it long enough. In that respect, they are a lot like casino games.

The big risk with practice accounts is that you’ll try out a risky and ultimately unwinnable investment approach, like day trading or options trading, and hit a lucky streak. This could embolden you to put serious money at risk just when your results are about to regress to the mean and deliver losses instead of profits.

If you have investment-related questions, or if you’d like to ask me about stocks you’re considering buying (or selling), you should join my Inner Circle service. Click here to learn more.

Online stock investing boosted the popularity of after-hours trading

Most stock trading takes place during the regular business hours of major stock exchanges. For the Toronto and New York exchanges, that means between the hours of 9:30 a.m. and 4:00 p.m.

In the 1990s, high-net-worth individuals and institutional investors gained the ability to trade before and after regular exchange hours, particularly on U.S. markets.

For a limited time only, sign up to get Pat McKeough's specific answers to your personal investment questions. Pat's proven expertise is available to guide the investment decisions of only a few new Inner Circle members. Click here to learn more about how you can benefit from membership in Pat McKeough's Inner Circle.

The bull market of the 1990s led to a greater demand from individual investors for similar “after hours” trading. The emergence of online stock investing pushed this demand even higher.

In 2000, Canadian brokerage firms began making “after-hours” trading on U.S. exchanges available to individual retail investors in Canada.

To trade in the after-hours markets, a retail investor must participate in online stock investing, and must become a customer of an Internet brokerage firm that has its own electronic-trading platform, called an electronic communications network, or ECN. Alternatively, the brokerage firm must have access to an ECN. Instinet is an example of a major ECN.

Some ECNs are regulated exchanges. Others are side businesses of broker-dealers. Still others are unregulated.

Unique risks of after-hours trading

After-hours trading differs from trading during regular hours in many ways. For one, there are far fewer buyers and sellers after hours, so there may be less trading volume on the stock you’re interested in. This may result in wide spreads between bid and ask prices, which makes it harder for you to buy at a favourable price. Thin trading also means that you’re likely to see more significant price fluctuations than during normal hours.

Moreover, even though access to after-hours trading has improved, this area of investing is still dominated by large institutional investors who have access to plenty of resources, so you’ll be up against some powerful competition.

From time to time, it might seem to be an advantage to have access to after-hours trading, but other times it will cost you money. Generally speaking, we think you are better off doing your trading during normal hours.

If you have investment-related questions like this, or if you’d like to ask me about stocks you’re considering buying (or selling), you should join my Inner Circle service. Click here to learn more.

Why choose Internet stock trading?

Some investors have made the switch from a full-service broker to Internet stock trading through a discount broker because it offers lower commission fees. Others have switched because they examined their results and discovered that their own investment ideas worked better than those of their brokers.

These investors feel they’ll do at least as well on their own, all the more so with the help of one or more of our Successful Investor newsletters and services. For them, making trades through a discount broker is a sound decision. The fact that this can cut their per-trade brokerage commission by as much as 75% is a bonus.

For a limited time only, sign up to get Pat McKeough's specific answers to your personal investment questions. Pat's proven expertise is available to guide the investment decisions of only a few new Inner Circle members. Click here to learn more about how you can benefit from membership in Pat McKeough's Inner Circle.

Don’t overindulge in the speed of Internet stock trading

Trading stocks online allows for quicker transactions compared to calling a broker. That’s good if you might otherwise abandon an important trade because you had to wait too long on hold, as sometimes happens.

However, carrying out trades in two seconds instead of 20 seconds or 20 minutes is unlikely to have any real effect on your returns. Price changes in that time frame are largely random. You will never get in or out quickly enough to have an advantage over a professional trader who has a direct link to the exchange.

Moreover, the lower costs and higher speeds offered by online stock trading can quickly lead otherwise conservative investors to trade too frequently. This, in turn, leads them to further cut the quality of their investments.

They may even take up short-term trading or day trading. There’s a large random element in short-term stock-price fluctuations, and some short-term trading newcomers do surprisingly well at first. Eventually, though, the odds catch up with them. That’s why most short-term traders wind up losing money. By the time their beginners’ luck fades, many are trading in dangerously large quantities.

Take the long view when Internet stock trading

Instead of short-term trading or focusing too heavily on fees, we recommend that investors spend more time contemplating what they buy and how it fits their investment objectives, as we do when we manage the portfolios of clients of Successful Investor Wealth Management Inc.

This way, you turn the odds in your favour: as your holding period grows longer, chances are your profits will improve, as well.

Today, you often see references to trading stocks online in the media, as if there’s something magical about entering buy and sell orders over the Internet, or making buy and sell decisions with the help of computer programs or Internet-based services.

You can, of course, cut your brokerage costs by trading stocks online through a discount broker. These brokers’ commissions tend to be lower than what you would pay by trading over the phone. However, if you are trading so much that this slight cut makes a material difference to your long-term returns, then your main problem is excessive trading, not high commissions.

Instead, we recommend that investors spend more time focusing on what they buy and how it fits in their portfolios. As their holding periods grow longer, chances are their profits will improve, as well. The Internet gives investors lots of information on publicly traded companies, including press releases, newspaper articles, company web sites and stock charts.

For a limited time only, sign up to get Pat McKeough's specific answers to your personal investment questions. Pat's proven expertise is available to guide the investment decisions of only a few new Inner Circle members. Click here to learn more about how you can benefit from membership in Pat McKeough's Inner Circle.

Trading online also allows for quicker transactions compared to calling a broker. That’s good if you might otherwise abandon an important trade because you had to wait too long on hold, as sometimes happens.

However, carrying out trades in two seconds instead of 20 seconds or 20 minutes is unlikely to have any real effect on your returns. Price changes in that time frame are largely random. You will never get in or out quickly enough to have an advantage over a professional trader who has a direct link to the exchange.

Automated systems that make decisions for you are another risky option. These essentially do two things: First, they narrow down the data you use when you make investment decisions. Second, they apply a fixed rule, or rules, to draw a conclusion or an investment decision from that selection of data.

These systems often seem to work for a time. Then they quit working, and begin pumping out unprofitable trades. This often happens at a time when their users are most vulnerable, such as during stock-market downturns.

It all comes down to one basic rule: if trading stocks online is as easy as those who promote trading systems make it out to be, why would anybody work?

The fund’s 10 largest holdings are Royal Bank, Manulife, EnCana, TD Bank, Potash Corp., Bank of Nova Scotia, Canadian Natural Resources, Suncor Energy, Research in Motion and BCE Inc. The $4.2-billion fund holds 41.3% of its holdings in resource stocks. It also holds 30.7% in finance.

Over the last ten years, RBC Canadian Equity posted a 9.5% annual rate of return. That’s just under the S&P/TSX’s gain of 9.7%. The fund lost 14.9% over the last year, compared to the loss of 14.4% for the S&P/TSX. The fund’s MER is 1.96%.

RBC Canadian Equity Fund is a buy.

The new operations should directly add just $0.02 a share to Bank of Nova Scotia’s annual earnings by 2011. However, the acquisition of E*Trade will increase Bank of Nova Scotia’s share of Canada’s fast-growing online investing market from 6% to 10%, based on the number of accounts. E*Trade has approximately $4.7 billion in assets under administration and 190 employees.

Bank of Nova Scotia also aims to sell its own financial products to E*Trade’s client base, including encouraging them to open Scotiabank bank accounts to let them easily transfer funds back and forth from their E*Trade on-line trading accounts.

Bank of Nova Scotia is a buy

The fund’s 10 largest holdings are EnCana, Potash Corp., Research in Motion, Manulife, Royal Bank, Suncor Energy, TD Bank, Canadian Natural Resources, Bank of Nova Scotia and Goldcorp. The $5.1-billion fund invests 45.3% of its holdings in resource stocks. It also holds 27.7% in finance. Over the last ten years, RBC Canadian Equity posted an 8.7% annual rate of return. That’s just over the S&P/TSX’s gain of 8.1%. The fund gained 5.9% over the last year, less than the S&P/TSX’s 6.6%. The fund’s MER is 1.99%.

RBC Canadian Equity Fund is a buy.