The Difference Between Trading and Investing
There are some basic differences between the "investment" point of view and the "speculative." It is a good thing to know these differences and make sure that you know exactly where you stand. Either viewpoint is tenable and workable, but you can create serious problems for yourself, and sustain heavy losses, if you confuse them.
One difference is that, as a speculator, you are dealing with stocks as such. A stock, to be sure, represents ownership in a company. But the stock is not the same thing as the company. The securities of a strong company are often weak; and sometimes the securities of a very weak concern are exceedingly strong.
Robert D. Edwards and John Magee, Technical Analysis of Stock Trends, Seventh Edition.(CRC Press LLC, 1998) 383.
An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.
Benjamin Graham and David Dodd, Security Analysis, 3rd ed.(New York: McGraw Hill, 1951), 38.
Traders aren't investors, and investors aren't traders. Few can do both at the same time, unless they're extremely well disciplined. Know your limitations.
Charles Kirk, The Kirk Report.
It is not enough to have good intelligence; the principle thing is to apply it well.
Descartes
These are just a few of the many divergent thoughts on the subject of Trading vs. Investing (except for the Descartes quote which I could not help but include). Stan Weinstein defines the difference as a matter of time frame. Edwards and Magee define an investor as someone who is solely concerned with the income yield of an investment, ruling out stocks that do not pay dividends.
My favorite definition, and the one that I use, is that of Benjamin Graham, which defines an investment as a low-risk operation, rather than as a type of asset. An investment according to the Graham definition would be an operation like the following: buying McDonalds stock (MCD) when it is undervalued (according to a thorough financial analysis) and selling it when it becomes overvalued (according to a second thorough financial analysis), and keeping a close eye on the health of the business in the meantime. A speculation according to Graham could be any of the following: a MCD daytrade or swing-trade, buying MCD on momentum, buying MCD based on rumors of a merger, etc.
The only thing that everyone seems to agree on is the importance of not confusing investing with speculation, and not using tactics that are appropriate to one activity while engaging in the other. This is very important, and also much more difficult than it sounds, especially given the fact that one asset may have attributes which make it appealing for both activities. The only way to protect yourself from the dangers of haphazardly combining speculation and investment is to develop plans that guide one or both activities and stick to them.
A few scenarios demonstrate the hazards of letting trades turn into investments or letting investments turn into trades:
- You purchase XYZ stock as an intermediate term trade, after a thorough technical analysis and a basic financial analysis. You further determine that there is a strong technical outlook for the stock market and the industry that XYZ operates in. You enter the trade with the plan of exiting if you lose more than 10% (but without entering a stop loss), and taking profits if you gain more than 30%. This is a sound plan, and one that many people have been successful with. The technical and financial picture looks great, and you have a high degree of confidence... but within two weeks XYZ has dropped to a loss of 11%. At this point, you take another look (but not a thorough look) and start to wonder if XYZ is in fact a great investment. Your snap judgement is that it is - but in fact, you have overlooked a red flag on the balance sheet which you would have noticed if you were doing a thorough analysis of XYZ. One month later, XYZ drops to a loss of 80%. At this point, you finally execute your exit strategy (70 percentage points too late), and leave the trade blaming the management of XYZ. You should blame your management of the XYZ trade instead. I have made this exact mistake in the past.
- You purchase ABC stock as a long-term investment based on a very time-consuming and thorough analysis. This analysis includes scrutiny of the balance sheet, calculation of intrinsic value using a host of metrics, getting acquainted with the profile of the executive officers and members of the board, etc. ABC stock is undervalued by approximately 25%, according to your water-tight analysis. You enter your investment with the plan of buying as much as you can until it hits $75, and selling when it hits $100, which is your estimate of the intrinsic value of each share (unless the business deteriorates). Let's assume that your analysis is flawless and that ABC does in fact hit $100 within two years after you buy it at $75. If ABC hits $50, you should buy as much as you can, provided that the underlying business is still sound - but you will be tempted to execute a stop loss, a trading tactic. You may choose to blame the management or PR department at ABC again, but the real culprit in your loss is, again, you.
Investments that "promise safety of principal" are hard to come by, except at the bottom of bear markets. I do have a few investments (Berkshire Hathaway, The India Fund), but most of my activities take the form of intermediate-term (multi-month) speculation. To keep these activities straight, I adhere to the following rules:
- Investments require thorough analysis and must provide reasonable confidence approaching certainty that principal will be safely returned, plus a gain, within 5 years. Investments are only bought below their intrinsic values and only sold when they become overvalued or the underlying business deteriorates. The rationale and rules associated with an investment must be put in writing before funds are committed.
- Trades require analysis of companies, the technical condition of their stocks, as well as analysis of markets, sectors and economic factors. Trades always have a stop-loss point, even though this stop loss may sometimes be mental rather than take the form of an actual order. Trades always have a selling strategy, either in the form of a profit target, or in the form of a timeframe, or in the form of a stop-loss which is increased as the price of the stock advances. The rationale and rules associated with a trade must be put in writing before funds are committed.
- Investments cannot become trades. Trades can only become investments if they meet all of the criterion for new investments, and this transition requires that the principal of the trade be protected from loss using a stop loss, or that this principal be sold.
By following these simple rules, I can ensure that both my trades and my investments will be profitable in aggregate (if not in every instance), and I can ensure that I never again make the mistake of letting a losing trade turn into a terrible 'investment'. Having sensible rules and sticking to those rules is the key to success, no matter what your strategy.
If you are interested solely in investing, you will want to read The Warren Buffett Way and Security Analysis by Graham and Dodd. You will want to do most of your buying when others are selling, as this is the ideal time to buy investments. You will need to be extraordinarily thorough, tough and patient to succeed as a long-term investor. You will benefit from economic growth, which is why careful long-term investing is not a zero-sum game.
If you are interested solely in 'trading' (by Graham's definition), then the best books that I can recommend are Lessons from the Greatest Stock Traders of All Time, Stan Weinstein's Secrets for Profiting in Bull and Bear Markets, Martin Zweig's Winning on Wall Street, Trader Vic - Methods of a Wall Street Master, If It's Raining in Brazil, Buy Starbucks, How to Make Money in Stocks and Technical Analysis of Stock Trends. You will need the ability to analyze the market, sectors, and companies. You will also need discipline to do your research and execute each trade as planned, because you will be competing with other traders with MBAs, non-public information, and access to extensive (and expensive) research. You will be competing in a zero-sum game, so you will need every edge that you can get.
Today I moved 15% of my account from cash into FCNTX, taking a slightly larger position in my safest fund, for reasons that are described below in my fundamental and technical market sensor readings.
- Technical Sensors: STRONG. Technical readings are very strong as the Dow closes above a major resistance line at 10600 for the second day, despite rising oil prices.
- Fundamental Sensors: NEUTRAL. Although high oil prices are still a concern and the index of leading indicators is pointing down yet again, the fundamental picture has improved due to weakening in the sociopolitical picture for the EU and tame CPI and PPI reports last week which increase the probability that we are only 2-3 hikes away from Fed stasis. High bond prices and ample cash on the sidelines also contribute to a good fundamental picture. The main concern right now is that our bond yield curve may invert, in which case the fundamental sensors will go right back to weak, and we will have a red alert on our hands.
- Evaluation of Market Sensor Readings: Cautiously optimistic and 10% in Cash. The logic matrix is now in sector 8.
- Some Allegory: Despite continuing uncertainty, the outlook on the surface has improved recently, indicating that it is now safe to survey previously unsafe areas. I am still not at peace with the current environment, but I will not allow my emotions to make me excessively cautious when the data does not yet warrant it.
Logical Thought of the Day:"It is illogical to clutch at victory when it has already escaped your grasp. Cut your losses - fighting for a lost cause will only deepen the extent of your defeat."
