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Are you a stock market investor or a trader?

5 August 2012 06:30 pm - 0     - {{hitsCtrl.values.hits}}

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It’s no exaggeration to say that the world of stock-buyers is made up of two kinds of people: Those who buy to hold and those who buy to sell. Put it another way, it’s made up of investors and traders. Many people believe investing in the stock market and trading in the stock market are one and the same, though there is a vast difference.

Investing
Investing is when you buy the stock based on solid fundamentals and hold it for the long run. When we say long, it generally means one year or more. The investor selects stocks based on what’s known as fundamental analysis, which involves analysing a company’s financial statements to identify its strengths and weaknesses, understanding the company’s markets, competitors and products and generally developing a thorough understanding of the business, its value and its long-term potential. You don’t pay much attention to the daily fluctuations of the market, or whether your stock goes up or down a few percent. You have found a company that you believe will become the next ‘The Company’, and you plan on owning a piece of this company for a long time.

Investors often look for companies that are ‘undervalued’, which means that they are intrinsically worth more than their share price suggests. Investors like these companies because in the long run their share prices will almost certainly rise.

The goal of an investor is to own stocks that will deliver stock price growth and decent dividends over the long term. True investors often reinvest their dividends in the stocks they own, because they believe that the companies they’ve bought are worth owning more of. Investors seldom have a firm idea about what price they would sell their shares for; serious investors often plan to hold on to their shares indefinitely.
Trading

Trading however is another matter entirely. When someone trades a stock, it is for a short period of time, generally between one day and six months. The trader is not looking for the next ‘The Company’, they are just looking for a stock that will move up (or down) a few percent quickly. Traders can and do make money in an up or down market and often use technical analysis as well as fundamental analysis to profit.
Traders often select stocks on the basis of what’s known as technical analysis, which involves looking at market data such as historical price movements, trading volumes and so on. Technical analysts use statistical tools and charting software to predict short-term stock price movements, although of course, gut instinct also plays a role.

The goal of the trader is to make quick profits on price differences. Traders often short shares in anticipation of price decreases, thus seeking to profit on both price rises and falls. Traders buy and sell often, frequently using borrowed money to fund trades.
One way to illustrate these differences is with a practical example. Warren Buffett and George Soros are two men who have made plenty of money over the course of their lifetimes. The two billionaires are similar in some respects; both are self-made men of relatively humble origins and both are noted philanthropists.

They are also very different. Soros was born in Budapest in 1930, and lived through the terrors of the Second World War and communist rule in Hungary, while Buffett was born in 1930 in peaceful Nebraska. For our purposes, however, the key difference between the two men is how they got rich.
Buffett is a legendary investor who made his money off long-term investments in companies like Coca-Cola, UPS and others, whose stocks he has held for decades. By contrast, Soros is a legendary trader, who once reportedly made a billion dollars in a single day in 1992 betting against the UK sterling. Soros, in other words, made his money off countless numbers of rapidly executed trades.

Buffet versus Soros, investor versus trader: Two very different approaches to the world of wealth creation.
The different types of market participants like traders and investors must know their role and act accordingly. Traders simply do not act like investors and vice versa. Trading requires a different set of thought processes that enables a person to view a trade simply as a profitable endeavor. The primary difference between trading and investing is your intention.



Common characteristics of traders
  •     Traders enter a position to make money.
  •     Traders will hold for a short period of time.
  •     Traders use technical indicators and charts.
  •     Traders cut losses.
  •     Traders take profits quickly.
Common characteristics of investors
  •     Investors will buy and hold.
  •     Investors enter long (or buying) positions.
  •     Investors will hold for a long period of time.
  •     Investors focus on fundamental analysis.
  •     Investors are not concerned with short-term losses.
  •     Investors let profits accumulate.
Both investing and trading offer their pros and cons.
Investing
Pros:
  •     Less time consuming and psychologically less stressful
  •     Statistically you are more likely to succeed than traders are in the long term
  •     More likely to have consistent percentage returns per year than traders are
  •     Less commission fees than trading
Cons:
  •     Lower percentage returns in the short term
  •     Easy to lose interest due to lack of involvement required. Usually leading to poor portfolio performance.
Trading
Pros:
  •     There is always money to be made somewhere in the short term
  •     If successful, a trader’s percentage gains are typically higher than investor’s
  •     Builds even more discipline than investing does (assuming you are successful)
Cons:
  •     High broker fees due to commission being taken on buy/sell orders
  •     More time consuming and considerably more psychologically stressful than investing
Three things to note when investing or trading

Capital preservation
Capital preservation must be seen as a long-term rule, and not be based on each and every trade. Limit your risk exposure to only trades that are very likely to go your way than not. Have a method to screen for these high probability trades based on your trading criteria.

Risk management
Risk is unavoidable, and we can’t get around it. People tend to think that investing or trading is a very risky thing to do. This statement reeks of an absolute bias and contains an assumption. First of all, risk is not absolute; it is relative to the individual undertaking the activity. Second, it assumes that in order to make above-average profits, you must expose yourself to bigger risks.

A competent investor or trader most probably won’t find investing or trading to be a risky thing to do. An experienced pilot wouldn’t find flying a plane to be particularly risky, whereas someone without a pilot’s license would think so. While there is always some inherent risk involved, the magnitude of risk is relative to a person’s knowledge, understanding, experience and competence.

Someone new to trading will think that trading is a very risky way of making money, and that is true – but to him. He doesn’t yet have a comprehensive understanding of how the markets work, how to get into high probability trades, how to manage his own emotions, and trading would definitely be very risky for someone like that to take the plunge without proper learning and experience.

As for taking big risks in order to make big profits, that may not necessarily be the case when it comes to trading or investing.
You can reduce risk by aiming for high probability trades or actively manage risk by monitoring and closing out your open positions if it seems that the market is not going your way. You can even completely avoid risk if there seems to be no good trades. There is risk in everything you do – whether you walk home, drive or date a stranger. It is OK to take risks. Have a risk-minimizing system in place so that you can come out profitable in the long term.

Invest in your knowledge
There are four stages of learning:
  •     Conscious competence: Knows what he knows, and knows what he doesn’t know
  •     Unconscious incompetence: Doesn’t know that he doesn’t know
  •     Conscious incompetence: Knows that he doesn’t know
  •     Unconscious competence: Knows that he knows
Many new traders are in the first stage of unconscious incompetence. They are more prone to losses because they are quite unaware of what they are doing due to their limited knowledge and experience. If you are a new to investing or trading any particular asset, accept that you really don’t know much about it. Make the subject your expertise and dedicate some time to learning more about it. Once you gain more experience with investing or trading, you may not feel anymore that it is so risky to trade compared to when you were clueless about it.

What’s better: Investing or trading?
There isn’t actually a hard-and-fast rule about which approach is better or more profitable.

First, your chances of making money and avoiding huge losses are better with a long-term investment strategy rather than a trading approach. Even if all you do is put money into a unit trust or index fund every month, reinvest your dividends and leave your money in the market for the long term, you’ll almost certainly earn a decent return. Trading is a lot more risky and you can (if you trade with borrowed money) lose more money than you actually have.
Second, trading is usually more expensive, because every time you buy or sell stocks you pay certain fees. If you’re an active trader, those fees can add up, and your returns therefore need to be very high to make up for your costs. In contrast, since you do less buying and selling as an investor, your returns can be a little lower because you have lower costs.

Finally, investing is a lot less stressful than trading, and with stress a leading cause of illness and depression, who needs more of it?
If you are new to the market, start with investing, learn the fundamental analysis. When you are comfortable with investing, you can start looking into the trading side of the market. From there work with what is most comfortable to you.

“Survive first, and make money afterwards”
– George Soros
“Investing Rule No. 1: Never lose money. Rule No. 2: Never forget Rule No. 1”
– Warren Buffett
 (Source: Theinvestorsjournal, Moneyweb, forextrading and
dailymarkets)
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