Are You A Trader or Investor?: A Very Important Distinction

I get questions all the time from clients, prospects and friends that go something like this:

“I was watching CNBC the other day and they were talking about XYZ stock and how it is about to pop. Should I buy it.”

Or

“I read online that XYZ stock just broke through a resistance level and is going to run higher. Do you think that is a good investment?”

Or

“I heard that XYZ is going to disappoint on earnings. Should I short it? How do you short a stock BTW?

As a financial advisor, these are all very dangerous questions.  We all wish we could buy a stock or short a few stocks and make huge returns all the time.  We wish we could buy a stock, watch it pop and then have a great story to tell our friends at parties.  The truth is that making such trades successfully is very hard and takes a lot of work.  That is one of the reasons the average investors continuously underperforms the market.

As much as I watch CNBC and read trading ideas online, I think they create a very unrealistic expectation about what it takes to trade stocks and be successful, consistently. We watch the traders on “The Halftime Show” and think, “wow I can be a good investor.” But many of these pundits are not just investors, they are traders.

What I often have to explain to people is that there is a very big difference between trading and investing. I’m sure this has been said somewhere else by someone much smarter than me so I can’t take credit but the way I think about the difference between investing and trading is:

You trade securities. You invest in companies

This is a very important distinction because the expertise required for each is much different.  The goal is much different as well.

Trading:

A trader’s goal is to take advantage of short-term mispricing in a security.  Short term could mean anywhere from a few seconds to a few months.  Traders are trying to identify times that the market hasn’t fully reacted to some information about a stock and they see an opportunity to take a position in that security before the stock reacts to that information.  That information could include a wide range of things from fundamental changes in the company, technical changes in a chart or a short squeeze on the stock. There is a skill required to identify the mispricing but also a discipline to know when to get out of the position.

Unless you have the time to devote to trading, it can be a dangerous thing to dabble in. I don’t want you to misunderstand me here.  If you are good at trading it can be highly profitable. The problem arises because many people lack the expertise and/or the time to devote to the craft but still think they can place some trades and make some good money because they heard an idea.  These are often the people who end up getting burned.  It is important to remember that the really successful traders in the world are very smart and spend endless hours studying charts, reading earnings reports and developing ideas.  They are profitable because they identify a mispricing in something that the general market doesn’t see and develop a strategy to express their idea.

Investing:

Investing, on the other hand, is often much different.  The goal is not to just find a short-term mispricing in a stock.  The goal is to find a company or sector that you think has the ability to return stronger growth and/or income than the current price is indicating.  Benjamin Graham said it best in his book “The Intelligent Investor”:  “The price is what you pay, the value is what you get.”  (As a side note, if you are interested in learning more about investing, this book should be you’re the first thing you pick up.)

This quote is often attributed to Warren Buffet because more than anyone he has put this quote into practice. He also uses Graham’s book as his bible.  The key thing investors like Buffett and Graham seek to identify is if a company’s long-term value, based on their projection of future growth and profits, is greater than the current cost of the stock.  If that is the case then it makes a good investment and something that they will buy and hold for as long as it is returning a value greater than the stock price.  In Buffett’s case, there are some stocks that he has owned for decades.  He first purchased American Express in the 1960s and still owns a 16% stake in the company today.

Now, I’m not saying that you should hold every investment for decades but if the long-term value exceeds the price it is something that could make a good investment.

This same investment philosophy can also hold true for sectors of the economy, countries, regions, etc. In recent years we have seen a move to more index investing. It is important to understand and remember that behind those ETFs are actual companies with revenue and earnings.  So while you may not be doing the due diligence behind each one of those companies, you think that basket of stocks will provide you with growth and/ or income over time based on their ability to increase revenue and profits. Investing in a larger basket of stocks may limit the potential upside but it also helps to balance the risk on the downside. So unless you have the time or expertise to do your due diligence behind a bunch of individual companies using indexes can be a much more prudent way to invest.

Final Thought:

I don’t want everyone to get the idea that I think trading is too hard so we shouldn’t do it while investing like Warren Buffett is easy so we should.  Very few people, if any, can duplicate what Warren Buffett is able to do.  His discipline, investment knowledge and passion for learning everything about a company are very rare. However, for the majority of the readers out there the best way to build long-term wealth is through a disciplined investment approach and not by trying to hit it big by trading in and out of a few stocks.

0 replies

Leave a Reply

Want to join the discussion?
Feel free to contribute!

Leave a Reply

Your email address will not be published. Required fields are marked *