Trading vs. Long-Term Value Investing

Often times, I receive inquiries from some of my readers as to the differences between being a trader and an investor. On the surface, these may seem to be synonymous terms but they aren’t and knowing the difference may save you a lot of heartache in the financial markets. Btw, I’m gonna speak only about the financial markets in this article (equities, currencies, derivatives, bonds, etc.)

First, let’s define a trader and an investor.

An investor is someone who has a long-term outlook on a market. These people may hold positions for many months or even years. One thing you must understand is that not every investor is a value investor. A value investor seeks to find undervalued companies and will purchase shares of that company’s stock in anticipation of an eventual price rise, whereas your ordinary investor simply buys and holds for their own reasons.

A trader is someone who seeks to profit from price changes in short-term to intermediate price fluctuations. A trader doesn’t care about underlying conditions or anything of the sort. The trader cares only about being able to enter a position at one price and exiting at a price that would turn a profit.

If you want an illustration, think of two guys who deal in Real Estate for a living. You have one guy who purchases a home, renovates it and sells it for a quick profit. Then you have a guy who buys a home, who also renovates it but he doesn’t sell for a quick profit. Instead, he rents it out in order to create a stream of cash flow as the home appreciates in value (or so he hopes). The first Real Estate guy would be the trader while the second guy would be a long-term investor. It’s the same in the financial markets.

Me — I’m a trader and here’s why. My goal in the markets is to turn a profit…nothing more. I couldn’t care less about value or any of the underlying conditions. I care only about whether a particular instrument will move and yield a profit. That being said, what you will have are many people who will tell you that long-term investing is the best way to make money in the markets and I would agree but only to a certain extent. However, holding long-term can also get you killed in the markets (I will explain shortly).

The biggest flaw I see in value investing is that many value investors don’t quite understand that value is what someone is willing to pay for whatever it is that you’re selling. Say for instance, you find a stock that you believe to be undervalued. In order to act on your belief, you purchase shares of that stock in anticipation of a rise in price. Here’s where the problem lies. Unless other market participants begin to buy that stock, it isn’t going to rise. Of course, if you have the capital, you can probably move the market a little (in hopes that others will see activity and join in) but not for long. As you can now see, value investing in itself means very little unless other people recognize that value as well and are willing to start buying. This isn’t at all to say that value investing is useless because that would be blasphemy and outright stupid, especially when guys like Warren Buffet, Carl Icahn and Seth Klarman exist. Value investing, in my opinion, is most rewarding if one can buy during a time of economic recession or even better — during a depression. If you can buy during those times, you don’t even have to be a genius to make money.

What you have to also understand is that there are lots of people who call themselves investors but are really traders turned investors. Meaning that those people entered a position for the purpose of turning a quick profit, but in order to avoid admitting that they made a wrong decision, they rationalize holding on to a loser by saying that they’re in it for the long haul. They believe that someday their position will come back to it’s original price. This happens with a lot of people who buy at the wrong part of an economic cycle. They may watch the news and hear of a booming stock market, and will buy the stocks of companies that have been pitched on TV by some of the network pundits. Little do they know, they’ve arrived at the party a little too late. They will hold onto their investments out of belief that this is “just a correction” only to find themselves deeply in the red at some point.

A trader, on the other hand, who’s sensitive to price would not allow themselves to get caught up in that way. If anything, when the tides are changing, the trader is adjusting his position from bullish to bearish. The trader is not only out of his longs, he’s also short. The trader places himself in a position to make money no matter what way the market turns.

If one can get into a long-term investment at the right time (back to economic cycles), the rewards are tremendous and the investor will probably come out much better than a trader. For instance — those who bought stocks after the market bottom in 2009 and held are doing much better than anyone else.

Conclusion: While we hear many people tout long-term investing as a holy grail of some sort, people like myself know that to be false. No matter how undervalued you think your investment may be, it means nothing unless other people are willing to get on-board and start purchasing that asset as well. The market for that stock (or whatever instrument) isn’t going to rise just because you purchased it — markets rise due to scarcity and high demand. The trader understands this and will act only if price shows that there is an imbalance between supply and demand. Unless this imbalance occurs, your investment will never appreciate in value.

Advertisements

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s