There are three important differences between investing and trading. Ignoring them can lead to confusion. A beginning trader, for example, may use the terms interchangeably and misapply his rules with mixed and unrepeatable results. Investing and trading become more effective when their differences are clearly recognized. An investor’s objective is to acquire long-term ownership of an instrument with a high level of confidence that its value will continually increase. A trader buys and sells to capitalize on relative short-term changes in value with a somewhat lower level of confidence. The goals, time frame, and confidence levels can be used to outline two completely different sets of rules. This will not be an exhaustive discussion of those rules, but it is intended to highlight some important practical implications of their differences. Long-term investing is discussed first, followed by short-term trading.
My mentor, Dr. Stephen Cooper, defines long-term investing as buying and holding an instrument for 5 years or more. The reason for this seemingly narrow definition is that when you invest for the long term, the idea is to “buy and hold” or “buy and forget.” To do this, you need to remove the emotions of greed and fear from the equation. Mutual funds are favored because they are professionally managed and naturally diversify your investment across dozens or even hundreds of stocks. This doesn’t mean just any mutual fund and it doesn’t mean you have to stick with the same mutual fund all the time. But it does imply that one remains within the investor class.
First, the fund in question must have at least a 5- or 10-year history of proven annual earnings. You must feel confident that the investment is reasonably safe. You are not continually watching the markets to take advantage of or avoid short-term ups and downs. You have a plan.
Second, the performance of the instrument in question must be measured in terms of a well-defined benchmark. One such benchmark is the S&P 500 index, which is an average of the performance of 500 of the biggest and best performing stocks in the US markets. Looking back to the 1930s, over any 5-year period, the S&P 500 Index has risen in price about 96% of the time. This is quite remarkable. If the window is extended to 10 years, it is found that during any 10-year period the Index has gained in price 100% of the time. The S&P500 index has gained an average of 10.9% per year for the last 10 years. So the S&P500 index is the benchmark.
If one only invests in the S&P500 index, one can expect to earn, on average, about 10.9% a year. There are many ways to get into this type of investment. One way is to buy the trading symbol SPY, which is an exchange-traded fund that tracks the S&P500 and trades like a stock. Or, you can buy a mutual fund that tracks the S&P 500, such as the Vanguard S&P 500 Index Fund with a trading symbol VFINX. There are others too. Yahoo.com has a mutual fund filter that lists dozens of mutual funds with annual returns greater than 20% over the past 5 years. However, one should try to find a filter that provides performance for the last 10 years or more, if possible. To put this in perspective, 90% of the roughly 10,000 mutual funds out there don’t perform as well as the S&P500 each year.
The fact that 10.9% is the average market return over the last 10 years is even more remarkable when you consider that the average return on bank deposits is less than 2%, 10-year Treasury yields are about 4.2% and 30-year Treasury yields are only 4.8%. Corporate bond yields approximate those of the S&P500. However, there is a reason for this disparity. Treasury bonds are considered the safest paper investments and are backed by the United States government. FDIC-regulated savings accounts are probably the next safest, while corporate stocks and bonds are considered slightly riskier. Savings accounts are possibly the most liquid, followed by stocks and bonds.
To help you gauge the issue of safety and liquidity, long bondholders are comparing the bond returns they receive now to the anticipated stock returns for next year. Consider that the S&P500’s anticipated return for the coming year is about 4.7% based on the reciprocal of its average price-to-earnings (P/E) ratio of 21.2. However, the index’s 10-year annualized return has been 10.9%. Bondholders are prepared to accept half of the stock’s historical return for added security and stability. In any given year, stocks can go up or down. Bond yields are not expected to fluctuate much from year to year, although they have been known to do so. It is as if bondholders wanted the freedom to invest both short-term and long-term. Many bondholders are therefore traders and not investors and accept a lower return for this flexibility. But if you’ve decided once and for all that an investment is for the long haul, high-yield stock mutual funds or the S&P500 index itself seem like the best way to go. Using the simple compound interest formula, $10,000 invested in the S&P500 index at 10.9% per year becomes $132,827.70 after 25 years. At 21%, the amount after 25 years is more than $1 million. If, in addition to averaging 21%, just $100 a month is added, the total amount after 25 years exceeds $1.8 million. Dr. C. correctly believes that 90% of one’s capital should be allocated to various such investments.
Now that you’ve allocated 90% of your funds to long-term investments, that leaves you with about 10% for trading. Short to medium term trading is an area most of us are more familiar with, probably due to its popularity. However, it is significantly more complex and only around 12% of traders are successful. The time frame for trading is less than 5 years and is more typically a couple of minutes to a couple of years. The typical probability of hitting a trade direction approaches an average maximum of around 70% when using a proper trading system, less than 30% without a trading system.
Even at the low end of the spectrum, you can avoid getting wiped out by managing your trade size to less than 4% of your trading portfolio and limiting each loss to no more than 25% of any given trade while letting your winners run until decrease by no more than 25% of their peak. These percentages can be increased after there is evidence that the probability of choosing the correct direction of a trade has improved.
Intermediate-term trading relies more on fundamental analysis that attempts to assign a value to a company’s stock based on its history of earnings, assets, cash flow, sales, and any number of objective measures relative to current price of their actions. It may also include future earnings projections based on news of trade deals and changing market conditions. Some refer to this as value investing. In either case, the goal is to buy shares of a company at bargain prices and wait for the market to realize its value and raise the price before selling. When the stock is fairly priced, the instrument is sold unless continued growth in the value of the stock is seen, in which case it is moved to the investment category.
Since trading depends on the changing perceived value of a stock, your trading time frame should be chosen based on how well you can shake off the emotions of greed and fear. The better you can remove emotions from trading, the shorter the timeframe you can trade successfully. On the other hand, when you feel waves of emotion before, during, or immediately after a trade, it’s time to take a step back and consider choosing your trades more carefully and trading less frequently. One’s ability to remove emotions from trading takes a lot of practice.
This is not just a moral statement. A whole universe of what is called technical analysis is based on the aggregated emotional behavior of traders and forms the basis of short-term trading. Technical analysis is a study of a stock’s price and volume patterns over time. Pure technicals, as they are called, claim that all relevant news and valuations are embedded in a stock’s technical behavior. A long list of technical indicators has evolved to describe the emotional behavior of the stock market. Most technical indicators are based on moving averages over a predefined period of time. The indicator time frames should be adjusted to suit the trading time frame. The subject is too vast to do it justice in less than several printed volumes. The lower level of confidence involved in trading is the reason for the large number of indicators used.
While long-term investors can confidently use just one long-term moving average to track ever-increasing value, traders use multiple indicators to deal with shorter time frames of fluctuating value and higher risk. To improve your results and make them more repeatable, consider your expectations of value change, your time frame, and your level of confidence in predicting the outcome. Then you will know which set of rules to apply.
