Sunday, December 9, 2007

Trading vs. Investing

Wow I really haven't been able to get myself up to write a post at all. A big part of that is that fact that I've been back trading for a little over a month now, and it really just takes up a big part of my life. I've always had a high variance as a trader and now that I'm no longer working for a firm, those swings seem magnified. Especially on the downside. So it's been much tougher to get back into the mood of writing, but hopefully I can start again.

It's really hard enough to explain what I do to someone who isn't knowledgeable about finance, but sometimes I find it just as hard to explain it to someone who's been working on the investment side of things (I have a few investment banking friends). So I'm going to write a short list of my opinions on the differences between trading and investing.

1. Traders make money through the mechanics of the market. This includes taking advantage of supply and demand, mass group psychology, etc. Investors make money through the assessment of the worth of a company, and base any projections/predictions on the mechanics of the company and its business.

2. An investors' aim is to buy something that is undervalued and sell it when it is overvalued. Hence the term "buy low sell high". A traders' aim is to buy something when someone else is willing to pay higher for it, regardless of its worth or value. Hence the term "buy high sell higher" (If you've never heard of this before you'll hear it on some shows that focus on traders, such as Fast Money on CNBC).

3. Investors use fundamental analysis because it is a study of the company and its business. Traders can also use fundamental analysis because having an objective valuation of a company means having more information. However, traders also use technical analysis, a graphical or quantifiable representation of past human behavior, to predict future behavior patterns in the markets. An investor who focuses on the company itself would find no use for that.

4. Investors should have much slower diminishing returns on investment because short run supply and demand does not have as big an effect on an investor's bottom line, while a trader can make a trade based solely on supply and demand and therefore have the terms of their returns completely dictated by the marketplace.

5. Trading would be a zero sum game IF there were no investors. I feel that investors are not part of the game of traders/speculators and so any losses incurred by investors in using the marketplace that are credited to traders do not enter into my considerations for a zero sum game. A market with only traders/speculators would be a zero sum game because it is self-contained. Investors' smaller emphasis on short run supply and demand separates them from the trading game.

6. The actual cost of stocks relate to investors' perspectives, not traders' perspectives. All stocks should be priced to theoretical perpetuity, ie. a present value based on an educated guess of how long the business will run. A trader's time frame will always be too short to fully take advantage of perpetuity while an investor can pass on holdings for generations to come.

Because of point 6, I am especially reluctant to give any advice on stocks because my perspective is that of a trader. If I tell you to sell, often it is because it is better to buy it back a week later. But as an investor, will you do just that?

1 comment :

Dara said...

This is great info to know.