Trading vs Investing
Let’s first take a look at each style. Investing means that you pore over a company’s financial statements, management, product lines, operational costs, barriers of entry, profit margin etc.. In other words, you look at a company’s fundamentals. If you think the market value of a company’s stock is below its intrinsic value, you buy it. Trading is on the other end of the spectrum… Entry and exit of a position are made based on thorough technical analysis of a stock. Which one is better?
Most of the financial articles and college economy classes teach people how to be an investor at an early age. They will throw tons of econ theories at you and cite Warren Buffet or Peter Lynch as living examples that investing is better than trading. What they do not tell you is that most of the investors lose money, let alone achieving anything remotely like 1 / millionth of what Warren Buffet or Peter Lynch has achieved so far. I still remember that Benjamin Graham, teacher of Warren Buffet, said in his famous book Security Analysis You are better off to buy a well-diversified mutual fund in the long run than pick individual stocks on your own. If you are determined to do it yourself, read on.”
From my experience, trading is more suited than investing for average people like you and me. All the people I know, relatives, friends and next door neighbors who are/were investors suffered huge losses in 2008. The problem is that they did not have huge gains during the Bull Run from 2003 to early 2007 to offset those big losses. Cut the losers and let the winners run. You might have heard of this phrase from time to time. It sounds simple. Nevertheless, very few people can follow that idiom. Most investors do exactly the opposite thing, which is cut the winners and let the losers run. When he has a winner after a number of losses, he would ask himself 500 times a day if that winner would reverse. The more he asks himself, the more worried he is. He ends up prematurely exiting his otherwise a very profitable position. However, when he has a loser, every time that loser bounces back a little bit (sucker rally caused by shorts covering), he sees a light at the end of the tunnel. Yet the position edges even lower. Does he keep asking himself “How is it possible? How it is possible since this stock has such a low PE? Why? Why? ” The position continues to edge lower while he is still pondering why his investments are rotting. I have seen people hold onto gigantic losers that are over 50% under the water. 50% is an understatement in 2008. Before an average Joe, like you and I know what went wrong with the company, the stock has been already crushed unrecognizable.
One reason that an investor cannot cut losers is that he has a very strong conviction when he decides to buy a stock after spending so much time trying to understate the fundamentals of a company. In other words, he is very biased by the time he finishes studying the fundamentals of a company. If, that stock goes against him, he will always fool him into something like “I am a long term investor and these company’s fundamentals are sound.” Before he realizes it, he has a pet. Here are a few classic losers in 2008. They all have sound fundamentals.
Click on the thumbnails to have a better view of these losers
MGM (MGM MIRAGE)
Drys (Dry Ships)
RIMM (Research in Motion Limited)
SIGM(Sigma Designs, Inc.)
A stock moves because of the underlying psychology of many participating traders/investors. It reflects the mental states of all these participants. Technical analysis works like a heart rate monitor that you can use to see what others are thinking and then you make a trading decision based on what you can deduce from the readings. If you are a pure technician, you spend no time reading anything about the fundamentals of that stock. The stock is just an electronic symbol that may show you XYZ symptoms of going lower/higher. You calculate /guesstimate/deduce the probability of the stock moving in your predicted direction. If your answer is 51%, you open a position.
As we can see, one of the biggest mistakes an investor makes is keeping a pet. With a seasoned technician, it cannot possibly happen since he might not even know what this company does. It is just a symbol to him. He can long a stock as easily as short the same stock. He uses solid risk management to avoid big losses, which is cutting the losers. There are good, bad and ugly technicians.
- Good technicians follow the idiom, cut the losers and let the winners run.
- Ugly technicians cut the winners as fast as the losers. These traders will always be around though. But they are not able to make consistent profits.
- Bad technicians slip into the investor mode, which Mr. Market will send them packing as quickly as they entered the market.
When Dick Fuld, the CEO of the now bankrupted investment bank, Lehman Brothers, testified on Capitol Hill, he said “We acted like investors. We did not cut our losses quickly enough to avoid the steep losses.” If you would like to invest in the stock market, buy a mutual fund or an index fund. Most people simply cannot beat those professional fund managers. Most fund managers have a bunch of highly educated people working for them and they spend more than 8 hours a day researching stocks. A lot of people who I met actually believe they can beat those fund managers consistently even if they only spend 1 or 2 hours a day at most on researching stocks.
Of course, this is a perennial debate of trading vs investing. Choose one suitable for yourself.