Investing

Investing

InvestingInvesting and Trading are two very different methods of attempting to profit in the financial markets. The goal of investing is to gradually build wealth over an extended period of time through the buying and holding of a portfolio of stocks, baskets of stocks, mutual funds, bonds and other investment instruments.

Investors often enhance their profits through compounding, or reinvesting any profits and dividends into additional shares of stock. Investments are often held for a period of years, or even decades, taking advantage of perks like interest, dividends and stock splits along the way. While markets inevitably fluctuate, investors will "ride out" the downtrends with the expectation that prices will rebound and any losses will eventually be recovered. Investors are typically more concerned with market fundamentals, such as Price Earning Ratios( P/E) and management forecasts.

Trading, on the other hand, involves the more frequent buying and selling of stock, commodities, or other instruments, with the goal of generating returns that outperform buy-and-hold investing. While investors may be content with a 10 to 15% annual return, traders might seek a 10% return each month. Trading profits are generated through buying at a lower price and selling at a higher price within a relatively short period of time. The reverse is also true: trading profits are made by selling at a higher price and buying to cover at a lower price (known as "Selling Short") to profit in falling markets. Where buy-and-hold investors wait out less profitable positions, traders must make profits (or take losses) within a specified period of time, and often use a protective stop loss order to automatically close out losing positions at a predetermined price level. Traders often employ technical analysis tools, such as moving averages and stochastic oscillators, to find high-probability trading setups.

A trader's "style" refers to the time frame or holding period in which stocks, commodities or other trading instruments are bought and sold. Traders generally fall into one of four categories:

  • Position Trader – positions are held from months to years
  • Swing Trader – positions are held from days to weeks
  • Day Trader – positions are held throughout the day only with no overnight positions
  • Scalp Trader – positions are held for seconds to minutes with no overnight positions

Traders often choose their trading style based on factors including: account size, amount of time that can be dedicated to trading, level of trading experience, personality and risk tolerance. Both investors and traders seek profits through market participation. In general, investors seek larger returns over an extended period through buying and holding. Traders, by contrast, take advantage of both rising and falling markets to enter and exit positions over a shorter time frame, taking smaller, more frequent profits. 


Investor

Investors usually uses fundamental analysis i.e. checks the firm’s cash flows, yields value ratios, prefers 'value' stocks, usually stays invested for the medium to long term and is focused more on income from dividends.

Trouble is, when you talk about trading or investing, you have to be clear about your perspective on time. It's simply no use talking about a day to day trader, they are concerned with minutes, usually 1, 5 and 10. Likewise, it's no use talking to a value investor about day trading because he's thinking in terms of years. And there is not just a superficial difference between trading and investing; a number of ordinary shares may for instance be unsuitable for holding on a long term basis due to their high volatility; such stocks may need constant attention and a long-term investor who is unable to keep checking his account everyday may be at a disadvantage to a trader who is able to access such information instantly. If you trade on different timeframes it is important not to confuse the timescales and effectively become a day trader while trading on weekly charts!

Longer-term investors are typically passive investors who lack the time or inclination to follow the market and will only trade infrequently so as to minimise dealing expenses. They typically build their share portfolios around a handful of key stocks that do not require constant monitoring and although they might do some housekeeping, their strategy is largely based on holding stocks for the long haul. This is also the preferred route for income investors. Long term investors view their investment as a stake in a company's future cash flows, which returns can then be injected back in the company to make it grow further or returned to them as a valuable dividend payment.

For the investor, the idea of weathering the ups and downs of being in the market is all part and parcel of the business. Long term investors will tend to have a preference for companies with high barriers of entry, have well-known brands, pricing power and competent management; all of which help to make a firm highly profitable with a stable revenue stream. Investing (i.e. putting your money to work over longer periods of time) also implies diversification, which means spreading your investments over a number of different asset classes so as to maximise gains while minimising potential losses.

Traders fall, in the main, into two sub-categories; the 'occasional' or 'active' trader. For the trader, the objective is to try and capture smaller moves of the market and then exit. This style of trading can be quite time consuming as one has to constantly follow the markets. Timing remains an all-important component of survival for traders who will try to take advantage of market volatility and try to identify chart turning points. A trader will usually go for share price momentum while studying stock market news flow with valuation being less important as long as the stock is moving in the correct direction.

Note: Remember though that investing is still trading as you are still buying and selling and thus you still need to know what you're doing.

Both trading styles carry risks. There is simply no way of looking 5-10 years ahead in any stock and having the faintest idea as to what conditions will be like then. Charts and stuff is not so important if you aim to hold for the long term. On the other hand if you are constantly getting in and out of positions, commissions can quickly add up and eat into your profits over long periods of times.

Day trading is sometimes compared to poker in that it is simply a zero-sum game; if there are four people sitting around a table playing poker, by the end of the day, two people will have won and two will have lost but no new money is created. This is quite similar to speculators who are in the stock market for short term plays - a business could not hope to sustainably make a 5% gain over a few days and as a result speculators are betting against each other. So on the one hand a speculator can take advantage of short-term pricing discrepancies but on the other hand if the speculator doesn't have a trading system with an edge what he may gain in one short-term bet may be offset by a losing trade and he still has two commissions to pay each time.

P.S. The techniques to use depend on your experience, investment time horizon, degree of risk you are willing to accept/retain, whether you have sufficient time throughout the day to manage intraday positions and of course on whether you are in for the long haul or only wish to trade shorter-timeframes. This doesn't mean that investing is better than short-term speculation or vice-versa. George Soros, Warren Buffett, and Richard Dennis are all examples of professional traders who trade over different timeframes but each is successful in his area. George Soros, for instance established the Quantum Fund for the explicit purpose of taking advantage of short-term and opportunistic foreign exchange moves while Warren Buffett is widely known as a value investor. Richard Dennis uses commodity options as a way to trade his way to major moolah. And you can always reach a compromise where you invest part of your capital in long-term positions while using the rest to trade on a short-term basis.


Are you a Trader or an Investor?

Are you investing in a stock or a company you must ask yourself? That may sound like a confusing question, but it is an important distinction and can get you in trouble if you don’t know the answer?

First, let’s be clear that either answer is okay. The problem arises when investors confuse one with the other or start out investing in a stock, then change their minds when something goes wrong.

Investing in a stock and investing in a company.

If you buy a stock:

  • You are buying because you sense a price movement for some reason (through technical analysis, market/sector news, and so forth)
  • You are interested in profiting from a price movement and, most likely, selling and moving on to another stock
  • You have no real interest in the company behind the stock other than it is in the right place at the right time

If you invest in a company:

  • You have done a thorough analysis of the company and believe it has long-term growth potential
  • You understand what the company does and its position in its market
  • If the price drops, you know why and can determine whether this is a short-term situation or a change that will have a long-term impact on the share price

A person who buys a stock is more precisely a trader, while a person who buys a company is an investor. A trader may not hold a stock very long or may hold it a long time, depending on its performance. An investor buys a company with the intent of holding on to the stock for a long time.

When Things Go Bad

As long as the share price is performing well, neither the trader, nor the investor has much of a problem. However, when the share price starts falling, that’s another matter.

The smart trader has an escape plan in place to prevent small loses from becoming big loses. The trader has no emotional attachment to the stock, so getting rid of the loser at a predetermined point is easy.

Many traders find that dumping a stock when it has fallen and reached their stoploss a good way to keep loses small. If you set your sell level higher, you are in danger of letting a normal market blip trip your sell signal, only to see the stock and market rebound.

The problem arises when the trader decides they really like this stock and don’t want to give it up so easily. In other words, they’ve quit being traders and become investors.

The Problem

The problem is they usually don’t know enough about the company to make intelligent decisions about whether to hold the stock or let it go. They are no longer smart traders and they aren’t smart investors. Any decision they make as an investor at this point will be a guess.

The investor is probably better off when things go bad, but only if you have the courage of your convictions. If the stock price drops, reassess the company and the market. Did you miss something? Has something changed? Or is now the time to add to your holdings?

Conclusion

It is okay to be either a trader or an investor, just don’t try to be both with the same stock. 


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