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Trading vs. Investing

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Neither approach is inherently better than the other, but each requires a unique skill set for success.

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You've been living underground
Eating from a can
You've been running away
From what you don't understand

--U2

Sarah buys 100 shares of JP Morgan (JPM) thinking the stock will go up a dollar or so ahead of the company's upcoming earnings report. Steve also buys 100 JPM thinking that global investment banking will grow over the next five years. Neither approach is inherently better than the other, but each requires a unique skill set for success.

Effective market participants are aware of the difference between trading and investing, and of which one they are engaging in when initiating risk in financial markets.

Obtaining Separation

Although the distinction is not always clear, the language of financial market professionals usually implies a difference between trading and investing. Consider, for example, Todd Harrison's observation that:

"As a trader, you're focused on the path. As an investor, you're more concerned with the destination."

Such language can be used to tease out factors upon which trading and investing tend to differ:

Time horizon. Perhaps the most consistently implied difference between trading and investing is time horizon. Traders are usually focused on the short term price action while investors are focused on the longer term.

Entry price. Investors are usually concerned about entering positions near key market turning points. Since their view is longer term, they need to catch a significant portion of a trend in order to profit. When trading, entry price usually depends less on the 'fundamental value' reflected by a security's price. Instead, a trader focuses on prices that present an attractive risk/reward profile in the near future.

Attention to daily information flow. Traders are often glued to their computer screens observing real time price movements (i.e., the 'flickering ticks') as well as scanning the news flow for tidbits that might influence their positions or give them an edge. Usually, traders employ significant amounts of information technology to help them make sense of the daily market environment. Investors are much less connected to the daily info flow, as it often seems like 'noise' to them. Instead, they care more about tracking information that pertains to their long term investing thesis and related trends.

Risk management. Traders tend to manage risk more actively and employ methods that prevent excessive losses. Investors are more passive in their risk management, and often let their positions run for considerable lengths of time before adjusting them (Odean, 1998). As such, traders rarely catch massive market moves at any point in time while investors are vulnerable to significant losses or 'draw downs' in portfolio value if their positions go awry.

Basis for decision. Investors often enter a position based on fundamental analysis. Fundamental analysis involves determining the value of a security relative to underlying business prospects (e.g., Lynch, 1989). It is possible that a good company might be an unattractive investment if the price of the stock is too high (Graham & Dodd, 1934). Traders, on the other hand, often care little about fundamental value and more about market psychology and technical price patterns. Why? Usually, near term price movements are often driven by sentiment (Wang, 2003), and are only loosely connected to fundamentals. Indeed, focusing on fundamental analysis may be a liability in some market contexts.

Table 1 sums up the differences:

Table 1: Trading Versus Investing

Trading

Investing

Time horizon

Shorter term

Longer term

Entry price

Any price that offers potential for gain and capacity for risk management

Close to market turning point in order to capture a significant portion of a trend

Attention to daily info flow

High--usually gets higher as time frame for trade gets shorter

Low--focus on info that influences the primary trend

Risk management

Active--use of stops and other methods to avoid big losses

Passive--less concern for near term losses and drawdowns

Primary basis for decision

Psychology, sentiment, technical patterns

Fundamentals, macroeconomic trends


Mix and Match

So, is trading or investing 'better'? There is no universal answer to this question, of course. Some feel that trading is generally a losing proposition. Others feel the same about investing. Although active trading has sometimes been found detrimental to performance of some individuals (e.g., Barber & Odean, 2000), evidence suggests that either style can be effective (e.g., Schwager, 1989; Soros, 1987; Steinhardt, 2001).

Of course, individuals need not be traders or investors exclusively. Some folks blend these styles by splitting their portfolios into two 'buckets.' One bucket may be speculative and include positions that are actively managed in a trading posture. The other bucket is longer term in nature and includes positions that are more passively managed--more of an investment posture to capture moves that are 'bigger picture' in nature. Hazards to this approach is mixing up the buckets--such as overtrading positions meant to reflect a long term thesis, or letting a bad trade turn into an investment.

Because financial goals, time horizon, view of the world, and risk tolerance differ between people (Alexander, Jones, & Nigro, 1998; Baker & Haslem, 1974), the ideal financial market decision-making style varies for each individual. Endeavor to craft a stylistic approach that works for you.

References

Alexander, G.J., Jones, J.D., & Nigro, P.J. (1998). Mutual fund shareholders: characteristics, investor knowledge, and sources of information. Financial Services Review, 7: 301-316.

Baker, H.K. & Haslem, J.A. (1974). The impact of investor socioeconomic characteristics on risk and return preferences. Journal of Business Research, 2: 469-476.

Barber, B.M. & Odean, T. (2000). Trading is hazardous to your wealth: The common stock investment performance of individual investors. Journal of Finance, 55: 773-806.

Graham, B. & Dodd, D. (1934). Security analysis. New York: McGraw Hill.

Lynch, P. (1989). One up on Wall Street. New York: Simon & Schuster.

Odean, T. (1998). Are investors reluctant to realize their losses? Journal of Finance, 53: 1775-1798.

Schwager, J.D. (1989). Market wizards. New York: Harper Collins.

Soros, G. (1987). The alchemy of finance: Reading the mind of the market. New York: Simon & Schuster.

Steinhardt, M. (2001). No bull: My life in and out of the markets. New York: Wiley.

Wang, C. (2003). Investor sentiment, market timing, and futures returns. Applied Financial Economics, 13: 891-898.
position in JPM

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