Day-trading my Baby's Future Away

Sure, why not? With a volatile market, tax benefits and a nice, long time horizon, frequent trading in your child's custodial account may seem like a great way to make some serious money. For your child, of course. In fact, it's a great way to de-rail the two best tools in your investor arsenal - dollar cost averaging and the beauty of compound interest. Lower the bar, have a nice day.

If you've decided to open a custodial account (called an UGMA) for your new baby, pat yourself on the back. Few people take advantage of these custodial accounts, which offer preferential tax treatments on the undoubtedly copious capital gains that you, as custodian, will be generating for your child. But, before the back patting gets out of hand, remember that long-term investing horizons and happy tax rates shouldn't mean that you should try every controversial investment strategy that comes down the pike. You shouldn't.

I know from whence I speak. Working at a brokerage firm years ago, I was continually amazed at how investors who considered themselves to be sensible and conservative in their grown-up lives, would play fast and loose with Junior's stash of cash. Trained as we are to abhor taxes, the favorable tax rates (UGMA's are partly tax-free, and partly taxed at your child's rate) seem an irresistible way to test your skills as a market timer and trader. Resist.

Let's walk through an (oversimplified) example. You establish an account with $5,000 and buy 100 shares of XYZ stock at $45 a share. You then pay a 3% commission of $135. You now have $4500 in shares, and $365 in cash, minus commission, in your account. Three months later, XYZ is at $52 a share, so you sell half your holdings. You generate $2600 from the sale (50 shares x $52 a share) and generate another commission of $78. Your account now has $2600 in shares and $2887 in cash, (minus all commissions) for a total value of $5487. Wow! Not bad for three months!

You press on. You take the $2600 you raised from the sale and buy 70 shares of ABC stock at $35 a share. Your new 70 shares cost you a total of $2450, and you pay $73 in commissions for the privilege. You now have $5,050 in stock and $364 in cash after commissions. (This is tedious, I know, but stick with it. It's worth it.)

But wait! You have to pay taxes on the sale of XYZ stock. You triggered a capital gain of $2600, which is taxable at 15%. You now owe $390. That's bad. At the end of this exercise, your share values are worth $5,050 (XYZ shares worth $2600 + ABC shares worth $2450), but… you don't have enough cash left over to pay all your taxes. You clean out your cash of $364, and pony up a bit more to pay your bill. At the end of the day, your $5,000 has grown to a paltry $5,024 ($5487 total value, minus $390 in taxes.)

Of course, that example is a hypothetical, offered to demonstrate the devastating effects of trading costs on your return. To really do it justice, we'd have to look at years of trading activity, which would drive both of us nuts. But it speaks to a higher reality – when it comes to investing, the less you fuss with your account, the better off you are likely to be.