RSS feedAfter my recent post examining the response to event risk (and when it manifests itself) depending on perspective as a trader or as an investor, I realized that it might be a good idea to throw my two cents in on the difference between trading and investing. It would seem that this is a pretty current topic in the blogosphere as The Peridot Capitalist and The Essentials of Trading blogs have been having a bit of a back and forth on this topic lately. Their two posts were both really interesting specifically because Chad Brand of The Peridot Capitalist is very much an investor and John over at The Essentials of Trading is more a trader. Not surprisingly, each argues with a slight bias for their personally preferred investment methodology.
John feels the main difference between traders and investors is “mainly in terms of the exit plan.” More specifically, he described the difference as follows:
Traders generally have them going in, meaning they have a specific set of criteria which will trigger an exit - often something related to price action, but not always.
Investors, though, handle things a bit more nebulously. They will exit a position when the fundamentals no longer support their being long. That, however, isn’t something which can easily be defined since there are so many factors involved. It’s not usually as cut and dried as falling short on the latest quarter’s earnings.
Chad uses a casino/gambler analogy to describe what he sees as the investing/trading paradigm. In his own words:
Here is an analogy for you; investors are the casinos, whereas traders are the gamblers. Investors have the odds stacked in their favor, just as the casinos are guaranteed winners over time because the games they offer have a win percentage built-in…
Traders, on the other hand, are trying to win big on short term trends, much like a blackjack player hopes for a hot shoe and then cashes out his/her chips. The gambler knows that they don’t have a statistical advantage but they play nonetheless, trying to make some money and getting out before they give it all back.
Now, before all you traders get up in arms over this definition. Chad does acknowledge that the odds are not necessarily stacked against a trader. In fact, to extend the gambling analogy for Chad, I would liken trading to counting cards. Stock traders believe that stock price movements have “memory” much like black jack. What happens in the past gives you a clue as to how things will act in the future. Traders use technical indicators and various techniques to measure the market’s attitude towards a stock - the supply and demand structure, enthusiasm, etc. Again, this isn’t a perfect analogy as one cannot mathematically conclude that trading strategies do in fact give you a concrete statistical advantage like counting cards does, but one can see how these techniques could give you some sort of insight into the price movements of a stock.
So, how do I view the difference between trading and investing? Well, as a lead in, I’d like to steal an anecdote that I read recently in Seth Klarman’s Margin of Safety. Imagine, a market for canned sardines. A trader doesn’t care what types of canned sardines, what flavor his sardines are, or where his sardines came from. He wakes up day in and day out and tries to buy the cans as cheap as he can and then sell them for as much as he can. An investor does care what’s inside the cans. He would open up cans, go to the factory, interview fishermen and find out whether or not these sardines will taste better as time goes on. He’ll buy the best sardines he can find; happy that he’ll either be able to eat the sardines in the future or that he’ll be able to sell these sardines for an improved price later.
Okay, weird anecdotes aside. Let’s try to answer some simple questions about investing and trading
What is the difference between investing and trading?
The basic difference between investing and trading is a difference of perspective. An investor looks as stocks as representative of fractional ownership in a company. They have an underlying value even if they decide never to sell the stock because the company will eventually pay out dividends and cash flow to shareholders. A trader looks as stocks as pieces of paper which can be traded day in and day out depending on market supply and demand. While the underlying business’ operations and success have an impact on a traders’ success, it often times does not matter to the trader because he believes that these fundamental concepts are represented in the stock’s day to day pricing action.
Are traders necessarily short term oriented and investors necessarily long term oriented?
Given the nature of trading and the tools that are available to a trader, a trader usually must think in a short-term oriented way. It’s difficult to construct technical indicators with multi-year time scales. This is because news, company performance and changing market environments will necessarily affect the supply and demand characteristics of a stock. This doesn’t mean traders won’t stay in a stock with strong upward momentum for months and even years. Most stocks, however, don’t maintain strong upward momentum for years and a trader is usually trying to time peaks and valleys in a stock’s price in order to capitalize on the frenetic behavior of people in the market.
Investors usually need to enter a stock with a long term outlook. They determine a value for the stock based on fundamentals and projections of future performance. They don’t sweat the day to day and week to week fluctuations because they know that, as long as business performance and fundamentals hold up, the stock price should follow suit. That being said, an investor must also understand the meaning of a stock’s price and is willing to sell a stock when its present value outstrips that of potential future value. For example, if a stock shoots up 100% in 3 days without any real change in fundamentals - i.e. many biotech stocks - an investor should be willing to count his blessings and sell his position knowing that the fundamentals may take months or even years to catch up to such a valuation. In such a case, the value found in fractional ownership in the company is outstripped by the speculative ownership of the stock.
Are trading and investing mutually exclusive?
The Benjamin Grahams, Seth Karmans, and Warren Buffetts of the world are probably going to hoot and holler at my answer to this. But, I don’t believe that investing and trading are mutually exclusive strategies. I don’t, however, believe in “fusion” strategies purported by many new investors (and sometimes seasoned investors) who want to get the best of both worlds.
Investing and trading as a mindset and perspective are mutually exclusive but, when practicing one, it can’t hurt to acknowledge the other. Many traders don’t like being called “traders” or “speculators.” They claim that they do look at fundamentals and that is what distinguishes them as true investors. The truth is, they shouldn’t be so taken aback by being called “speculators.” It’s not a bad word. And, it doesn’t mean you are a common gambler. It just means that you look at a stock based on its price performance and act accordingly. Most traders look at fundamentals only to check that the company behind the stock isn’t about to collapse or to make sure that recent price strength hasn’t put the stock in such a ridiculous pricing stratosphere that the demand for the stock could come crashing down at any minute. These are ideas which come from investing, but rarely are they capitalized on when using a trader’s mindset. Fundamentals, to a trader, ought to be viewed as a safety net rather than a motivation for action.
Getting back to the point, an investor can often use technical analysis and trading strategies to their advantage. Particularly in trying to maximize near term buy and sell decisions. In the grand scheme of things for an investor, trying to time a buy and sell isn’t necessarily important as most investors enter an investment looking for long term value that far outstrips few percentage point gains from day to day. Still, acknowledging trading strategies can help an investor make more informed decisions about short term price actions and determine whether he has more value in his fractional ownership in the company or simply in his ownership of the company’s stock.
Case Study
To demonstrate, let’s take a look at internet stocks. During the first bubble, many traders of internet stocks convinced themselves that they were “investing” in these companies because the internet was a fast growing sector and that one day valuations would justify prices. This despite the fact that they traded these stocks based on current price movements - particularly the very sexy and, in hindsight, completely irrational upward trends in prices. For these traders, it was not the potential future growth of the companies and it definitely was not the current performance of these companies (many were marginally profitable at best), it was the market demand for these stocks from which they derived profits.
True investors would never buy a stock which is fairly valued (or clearly over valued as in the above example) even if there was strong price momentum. They may, possibly, buy such a stock if the business is showing strong earnings and cash flow growth, but this would have to be verifiable not simply generally assumed. In the case of internet stocks, an investment case can be made for some internet and tech companies - Google, Amazon, Microsoft, etc. - and this is because they have verifiable business strategies coupled with true performance in earnings and cash flow growth. Furthermore, while these companies trade at premiums to many others, their current valuations could typically be classified only as fairly valued given reasonable assumptions of growth. Future earnings growth can propel these stocks to new, higher prices without fear of loss due to valuation premium contraction.
Conclusion
As seen above, while investors and traders can often utilize each other’s thinking in their decision making, it is difficult to apply both to an investing strategy due to a mismatch in their intrinsic perspectives on the value of a stock. As traders believe that value is derived from market supply and demand, they can only at best acknowledge fundamentals as support for their investment decisions. Investors believe value is derived from fundamentals in the business the stock represents and as a result can’t pay too much heed to a day-to-day changes in market demand for the stock.
