The Difference Between Trading and Investing II: Divergent Definitions of Risk

My primary timing system, which involves comparing the weekly open-to-close change in the RSP ETF (an unweighted equivalent of the S&P 500) is still on a buy signal. I have had several successful trades in the last few weeks (SMTS:%40 and WLDA:30%). I always use a stop-loss with intermediate-term trades, and I always move the stop loss above my purchase price when I hit 15-20% profit. At 25-30% profit, I generally set the stop to 10% below the current stock price, and periodically adjust it upward. So, when SMTS took me to 50% profit, I 'locked in' a 40% profit by moving up the stop loss. I still think that WLDA and SMTS are great companies, and I may look to re-enter SMTS when it recovers its upward momentum.

I buy stocks with technical and fundamental strength, and I usually insist that they are undervalued according to a variety of metrics. I usually stick to sectors and industries that are currently strong vs. the market, or that are likely to become stronger vs. the market according to Peter Navarro's sector rotation theory, but I will occasionally buy an extraordinarily strong stock in a weak industry (such as WLDA, which resides in the weak airline industry).

After extensive investigation, I have decided to look for a good entry point in XLU, the Utilities ETF, which has been in a rock-solid uptrend so far this year. Utilities are considered to be a defensive sector, and Buffett has been buying them lately, so with a 10% stop loss, this looks like a good trend to enter soon. I am looking into other ETFs as well - after all, I don't feel the need to prove that I am clever - only the need to grow my accounts with controlled risk. An ETF following a sector with strong fundamental and technical attributes is good enough for me, especially if the top holdings of that ETF hold up well under fundamental, technical, valuation, management and ownership analysis.

Divergent Definitions of Risk Between Traders and Investors

I realize that many see the investing vs. trading issue as a false dichotomy. I agree that there is much validity to this point of view - after all, both traders and investors want to make money with minimum risk. However, as someone who tries to absorb all of the wisdom available on winning in the financial markets, and who cannot help but notice contradictions between major schools of thought, I find this distinction to be useful. In my last post, I mentioned that one of the major differences between traders and long-term investors was that traders tended to focus more on stocks themselves, whereas long-term investors focus more on the underlying companies. Today, I would like to share what I see as the second major difference between these two schools of thought: divergent definitions of risk.

I think that one of the biggest differences between value investors like Buffett and traders like William O'Neil is in how they define risk. Buffett defines risk as the risk of business failure, and assumes that over long periods of time, a company's stock will reflect the strength of the business - this approach restricts him to a small set of companies, specifically those with earnings and cashflows that are sufficiently predictable that the intrinsic value of their shares can be estimated with a high degree of certainty. Because such companies only go 'on sale' occasionally, and because out-of-favor stocks and subject an investor to illiquidity in the short-term as stock may continue to decline and take years to be properly valued, a strong stomach and a long time horizon are required for value investing. However, strict value investing also relieves an investor of the burden of market analysis. Basically, value investors go against the market when they are certain of success.

The other school of thought, and the one that I mostly operate under, defines risk as market risk, and technical analysis of the market and individual stocks is essential for success in this school. That is not to say that there is no analysis of the underlying companies or market fundamentals by traders.

I am willing to operate under either set of rules, but I feel more comfortable using the rules laid down by Stan Weinstein, Martin Zweig, William O'Neil and Peter Navarro than trying to follow Buffett. After all, if you are going to argue with the market like Buffett does, you need to look at every possible problem that could arise in the business, and I am not confident of my ability to uncover potential problems at the same level as Warren. However, given the right setup (which does not come around that often), I will commit funds and manage them according to "value investor" rules.

For the most part, I am a trader, but I focus on trades in stocks that are undervalued, which gives me an edge over the many traders who ignore valuation entirely.

• Technical Sensors: The technical sensors are still STRONG, given that the 4% model is still issuing a buy signal.



• Fundamental Sensors: The fundamentals of the market, which include unattractive bond valuations and continuing economic growth with low 'official' inflation, continue to be NEUTRAL. We had great consumer confidence numbers recently, but there are still ample reasons to worry - among those reasons is well-reasoned suspicion of the recent GDP number.



• Evaluation of Market Sensor Readings: Cautiously optimistic and 10% in Cash. We are still in sector 8 of the logic matrix.



• Some Allegory: We came under attack from rising oil prices and unexpected explosions causing the crew on the bridge to rock from side to side but not inflicting serious damage. Yellow alert.

Logical Thought of the Day, courtesy of Sun Tzu:"The art of war teaches us to rely not on the likelihood of the enemy's not coming, but on our own readiness to receive him; not on the chance of his not attacking, but rather on the fact that we have made our position unassailable."