There are three important differences between investing and trading. Ignoring them can lead to confusion. For example, a novice trader may use these terms synonymously and misapply their rules with mixed and unrepeatable results. Investing and trading become more efficient when their differences are clearly recognized. The investor’s goal is to acquire long-term ownership of the instrument with a high degree of confidence that its value will continue to grow. The trader buys and sells to capitalize on short-term relative changes in value with a slightly lower confidence level. Goals, time frames, and confidence levels can be used to define two very different sets of rules. This will not be an exhaustive discussion of these rules, but 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 someone invests for the long term, the idea is to buy and hold or buy and forget. This requires eliminating the emotions of greed and fear from the equation. Mutual funds are preferred because they are professionally managed and naturally diversify your investments into tens or even hundreds of stocks. This does not mean just a mutual fund, and it does not mean that a person has to stay in the same mutual fund all the time. But this means that the person remains within the investment class.
First, the fund in question must have at least 5 or 10 years of proven annual return. You need to be sure that the investment is safe enough. You don’t constantly watch the markets to take advantage or avoid short-term ups and downs. You have a plan.
Second, the performance of the tool in question must be measured against a well-defined benchmark. One such indicator is the S&P 500, which is the average of the 500 largest and most profitable stocks in the US markets. Looking back to the 1930s, the S&P 500 rallied about 96% of the time in any five-year period. It is wonderful. Expanding the window to 10 years, he finds that over any 10-year period, the index has risen in value 100% of the time. The S & P500 has grown at an average annual rate of 10.9% over the past 10 years. So the S & P500 is a benchmark.
If a person simply invests in the S & P500 index, they can expect to earn an average of about 10.9% per year. There are many ways to enter this type of investment. One way is to buy the SPY trading symbol, which is an exchange-traded fund that tracks the S & P500 and trades just like a stock. Or you can buy a mutual fund that tracks the S & P500, such as the Vanguard S&P 500 Index Fund with the VFINX trading symbol. There are others. Yahoo.com has a mutual fund verification system that lists many mutual funds with annual returns of over 20% over the past 5 years. However, you should try to find a screener that gives results over the past 10 years or more, if possible. By comparison, 90% of the 10,000 or so mutual funds in existence do not perform as well as the S&P 500 every year.
The fact that 10.9% is the market average over the past 10 years is all the more remarkable when you consider that the average yield on bank deposits is less than 2%, the yield on 10-year Treasury bonds is about 4.2%, and the yield is 30 -year Treasury bonds is only 4.8. %. Corporate bond yields are approaching those of the S & P500. However, there is a reason for this discrepancy. Treasury bonds are considered the safest of all paper money investments because they are backed by the US government. FDIC-regulated savings accounts are likely next in safety, while stocks and corporate bonds are considered a little more risky. Savings accounts are probably the most liquid, followed by stocks and bonds.
To help you address the security and liquidity issue, long-term bondholders compare the bond returns they are currently receiving with the expected stock returns next year. Bear in mind that the S & P500 is expected to return about 4.7% next year, based on the inverse of its average price-to-earnings (P / E) ratio of 21.2. However, the index’s 10-year annualized return was 10.9%. Bondholders are willing to accept half of the historical stock returns for added security and stability. Stocks can rise or fall in any given year. It is expected that bond yields will not fluctuate much from year to year, although this is known. As if bondholders want to be able to invest in both the short and long term. Thus, many bondholders are traders, not investors, and settle for lower yields for this flexibility. But if someone decided once and for all that investments are long-term, then the best option for him would be high-yield mutual funds or the S & P500 index. Using a simple compound interest formula, $ 10,000 invested in the S & P500 at 10.9% per annum becomes $ 132,827.70 after 25 years. At 21%, the amount in 25 years is over $ 1 million. If you add just $ 100 a month to the 21% average, the total is over $ 1.8 million in 25 years. Dr. S. rightly believes that 90% of the capital should be directed to several such investments.
Now that you have allocated 90% of your funds for long-term investment, you have about 10% left for trading. Short to medium term trading is an area that most of us are more familiar with, probably due to its popularity. However, it is much more difficult and only about 12% of traders succeed. The time frame for trading is less than 5 years and most often from a couple of minutes to a couple of years. The typical probability of being correct in the direction of a trade approaches an average high of about 70% when the appropriate trading system is in use, to less than about 30% without a trading system.
Even at the lower end of the spectrum, you can avoid getting wiped out by controlling your trade size to less than 4% of your trading portfolio and limiting each loss to no more than 25% of any given trade, allowing your winners to run until they are no more than 25% less. % of its peak. These percentages can be increased after there is evidence that the likelihood of choosing the right direction for the trade has increased.
Intermediate trading is based more on fundamental analysis, which attempts to determine the value of a company’s stock based on its history of earnings, assets, cash flows, sales, and any number of objective indicators in relation to its current stock price. It may also include forecasts of future earnings based on news of business agreements and changing market conditions. Some call it value investing. In any case, the goal is to buy the company’s shares at a bargain price and wait until the market realizes their value and increases the price before selling. If the share price is fair, the instrument is sold if there is no continued growth in the share price, in which case it would classify it as an investment.
Since trading depends on the changing perceived value of the stock, your trading time frame should be chosen based on how well you can separate yourself from the emotions of greed and fear. The better a person removes emotion from trading, the shorter the time frame in which they can successfully trade. On the other hand, when you feel a surge of emotion before, during, or immediately after a trade, it’s time to take a step back and think about choosing your trades more carefully and trading less often. Getting rid of emotions in trading takes a lot of practice.
This is not just a moral statement. The entire universe of so-called technical analysis is based on the cumulative emotional behavior of traders and forms the basis of short-term trading. Technical analysis is the study of the dynamics of the price and volume of a stock. Pure technicians, as they are called, claim that all relevant news and valuations are embedded in the technical behavior of stocks. A long list of technical indicators has been developed to describe the emotional behavior of the stock market. Most technical indicators are based on moving averages over a predetermined period of time. The timeframes of the indicator should be adjusted in accordance with the timeframe of the trade. The topic is too big to do justice to it in less than a few volumes. The low level of confidence in trading is the reason for the large number of indicators used.
While long-term investors can confidently use only one long-term moving average to track steadily rising value, traders use multiple indicators to deal with shorter fluctuating value time frames and higher risk. To improve your results and make them more reproducible, consider your expectations for the change in value, your time frame, and your level of confidence in predicting the outcome. Then you will know which set of rules to apply.