The difference between trading and investing
I am primarily a day trader/swing trader. There are many approaches, techniques, and tactics, but the way I think of trading is the exploitation of the deviation of price from a prevailing trend. It is crucial to identify the prevailing trend for the time frame you are trading. There are 5 minute, 10 minute, 15 minute, half hour, 1 hour, daily, weekly, monthly, etc. The larger time frame is generally more dominant, but you don't trade off of a weekly chart when you are looking for a quick 10 cent scalp off of the opening bell. These different timeframes do tend to interact, but I won't get into detail on that. I just want to paint a picture of what trading is to me as the guy who trades intraday and on an overnight hold basis through swing trading. There are many trends within one stock that can be discerned depending on time frame, and many ways to profit from mispricing, but what I want to talk about is investing.
Investing, to me, is the purchase of a stock because of a longer term conviction in the fundamentals of a company. This means that I am not looking at the share of ownership in the firm as just a piece of paper to be traded when it pops for a quick gain, but rather as my vote of confidence in the business model, the management team, and most specifically the management teams ability to execute the business model.
Notice how I emphasize business. Someone might say, gee, well I want to invest in gold. Well, the way I see things, that is not an investment. That is a long term trade. I understand how it is acceptable to say that you are "investing" in gold because you buy it with the expectation of it appreciating in value, but I really see that as more of a very long term trade. It is more of an attempt to exploit temporary deviations in price from a prevailing trend, and in this case a multi year trend.
With investing, I focus on a business that is going to create value. That is to say, there is not something of value yet, but through the execution of their business plan the business creates something that people will value. That good or service would not be there for consumption if not for that business.
If my cousin were to create a pizza parlor in a shopping center, that business would create his certain brand of pizza that would not exist in the market until his business made it. I am confident in his abilities and give him 25,000 dollars and take a 30% equity stake in his business which entitles me to a share of revenue. Over the next 5 years, his business is successful and grows and my share of ownership increases in value as his revenues increased because my stock is valued at a multiple of trailing revenues.
The only similarity between investing and trading is that I am expecting an increase in value on my capital. However, the modes of analysis vary greatly. In trading, I seek to exploit a pricing inefficiency based on a certain time frame. In investing, I am looking to fund a business that based on my analysis will create something of value, make profits, and grow in value over time.
Anyone who has run a business, started a new business, worked with new businesses, or had some level of management responsibility with a business, knows that businesses are nothing more than organizations of people united around a common purpose to turn a profit. Business organizations are a team, like in baseball, football, basketball etc.
A lot of people that know nothing about business or sports think that you can just flip a switch and things come together for profit, growth, a pennant, a superbowl, a championship ring, etc. Then they gripe about things non stop when they are not instantly gratified.
Take for example the Houston Texans. They are an expansion football team that launched in 2002 and have suffered nearly a decade of being the league's whipping boy. The original QB, David Carr, was regularly a record maker in the number of sacks per game. The offensive line was not cohesive, but his slow release only made matters worse. The coach, Dom Capers, was supposed to be a defensive guru and had success with Carolina when they started up, but ultimately got canned at the end of the 2005 season. With the top pick in the 06 draft, Mario Williams, was looking to be a big piece of the puzzle that would stop the manhandling by the Colts and other divisional opponents. He was traded to the Bills where he continues to eat up salary cap space without anything notable in defensive stats.
After so many misteps over the years, the Texans are now 10 and 1 and should get home field advantage in the playoffs this year. They are a higher powered offense and with the addition of Wade Phillips as defensive coordinator, Houston is now number 7 in rushing defense.
If the Texans were a stock, it would probably resemble one of those internet stocks from the late 90's where there was a huge pop at the IPO, some follow through, but a whole lot of nothing. Now the stock would be popping.
The thing is that it takes a long time for businesses to come together whether they are brand new or an older business which has seen many iterations of personnel turnover. The mode of analysis for an investment play has to be one of understanding the operational details to make a valuation, whereas trading is just a price play.
I give this very long winded piece because I have a lot of time on my hands today due to the light volume market, but because I also feel that a lot of people do not realize the difference between investing and trading.
Many people believe that they are investing, but the reality is that they are approaching it with the lens of a trader.
Put it this way, we have all heard the term day trading, but there is no such thing as day investing. People are people, and business organizations are collections of people just like the Houston Texans. As long as that is the case, all business investing has to be looked at in terms of years. There has to be allowances for mis steps, miscalculations, personnel turnover, and numerous things going wrong before something can go right. I'm not talking about giving management a free pass. I'm talking about counting on management to screw up, but then become better after learning from their screw up so that after they take 3 steps forward, 10 steps back, then 20 steps forward.
This learning from screw ups applies not only to the businesses we invest in, but to ourselves as investors. The onus is upon us to NOT take management's word at face value but to read between the lines and listen to what they say in the context of their performance. If they are known to be overly optimistic, then the onus is upon you to discount their projections and invest appropriately as opposed to reacting in shock and horror after earnings report a miss.
This might be too much for the average person to endeavor, and a multi year investment is just beyond the scope of their investment time horizon. But as Warren Buffet likes to say, the markets are a means of transferring wealth from the impatient to the patient.
As a day trader I can make a pretty decent living doing what I do. However, it is not lost on me that the real wealth, I'm talking about multi millions if not billions, is made by investing.
