Trading and Investing: Similar Principles, Different Time Frames

Successful trading and great investment results share common themes.  While Dr. Brett Steenbarger's work attracts the attention of active traders, investors can also learn from the key principles.  Only the time frame is different.

As markets once again approach new highs, it is wise to review these fundamental precepts.

Key Steps to Success

The process for successful investing may seem easy to state, but most find them difficult to implement.  Here are the key steps:

• Develop an approach that has an advantage.  We call it "edge" and describe how to find it.  Dr. Brett makes the analogy to the card counter at blackjack, an example we have also written about.  Warren Buffett finds it by discovering good businesses at good prices, while not worrying about recessions.
• Maintain discipline.  Over several weeks we have shown the need for investors constructing an ETF portfolio to develop and adhere to a system.  Ours is not the only one that works.  The key is having enough confidence to stay with your method.
• Do not fear success.  In particular, the investor must not be afraid of winning  big!  Bull markets repeatedly hit new highs and also include corrections.  It is important to be on the right side of big moves.
• Manage investment size.  No money management system can turn a losing method into a winner, but poor money management can cripple the best system.  Many traders and investors make oversize plays based upon what they hope to gain rather than what they can afford to lose.  They either suffer big losses or make untimely sales as very normal variations create psychological pressure.
• Have an exit strategy.  There are many choices of exits, but all involve a recognition of when a trade has not worked -- some form of a stop.  We discussed the special need for stops in ETF trading, proposing our method for portfolio adjustment.  The Steenbarger "penalty box" approach is a similar theme.

Conclusion

Investors who focus on the list of market worries hammered on daily by news media and many popular blogs will always find reasons not to invest, even as the market makes new highs.  It is important to take general news in the context of the overall tradeoff between equity and bond returns, which remains quite positive for equity investors.

Comments

[Bill aka NO DooDahs!]

Buffett as a derivatives trader.

http://www.portfolio.com/views/blogs/market-movers/2007/11/05/warren-buffett-derivatives-speculator

[oldprof]

Josh-

Thanks for your question. One difference between me and others is that I do not comment on everything. I might have a private opinion, but I try to limit my writing topics to things where I provide some real edge. This is mostly in the areas of research methods and identifying experts. Those two themes can take one a long ways.

I do not have a trading position or interest in the bond insurers. I have noted your comment, and I agree that there is potential for investigation.

Thanks,

Jeff

[VennData]

Just because Buffet may buy a currency future, silver or anything besides a value stock doesn't make him a speculator, or a trader.

Futures may be easier ways to set a position now, while liquidity issues prevent creating the entire position non-synthetically in the short run.

Selling PetroChina may be a view on its over-valuation, not necessarily an intended trade (or even a political response.)

Euro future(s) etc. may also be a hedge to a forty billion dollar portfolio that's losing value daily (a big dollar position is in fact a speculation! Moving away from it would seem to me to be less speculative and simply prudent.)

A speculator / trader is someone who forecasts market psychology. An investor is someone who forecasts future cash flows - Ben Graham's voting machine vs the weighing machine. Buffet is an investor.

[Josh Stern]

Jeff, I'm looking forward to see if you have any commentary on Cramer vs. the bond insurers. You have written so much on the theme of media vs. experts and how to make money, and here is a hot topic where there is potentially a lot of easy money to be made on either the long or the short side by getting it right. Should we believe Cramer that these companies are "probably worthless"? Can it be true that a high percentage of their AAA and AA rated credit default swaps are actually going to have to pay out? If not, then some of these companies selling at half book value and 4-5 times cash flow are screaming buys. Or maybe the third possibility is that they are long term screaming buys but the hysteria from Cramer and the stupid MER has knocked down the swaps far enough that they are in for yet another quarter of big accounting losses so the smart money knows the short side is still a good "media risk trade"? Whatever your views, this is the best case example since I've been reading you on this theme.

[Bill aka NO DooDahs!]

I think the timeframe issue is a red herring. Do we buy to own a stream of future cash flows, or do with buy in order to make a profit when selling? The Magic Formula value trader holds for a minimum of 364 days (losses) and has no maximum timeframe, but he is a trader, because he buys to sell.

Buffett is a trader. Investors don't play with currency futures contracts, although they might buy foreign bonds provided they hold them until maturity. Investors don't sell PetroChina when it's "overvalued" because the "preferred holding time is forever" for an "investor."

I think 99.9% of people in the markets are traders of one timeframe or another. Even "angel investors" and "venture capitalists" are really just traders. Maybe the 0.01% of pure income buyers are investors …

[Tim]

Jeff, I see the book on your sidebar: "Irrational Exuberance" and the phrase that comes to mind is "irrational pessimism of experts". Everyone wants to call the reason for the next downturn. I find there are so many great investment opportunities almost no one is looking at while they worry about the overall economy or market. I just need more time to do my research. Keep up the good info. You really are a voice of discipline and reason and I hope more are reading your comments.

[John Forman]

I'm so glad to hear someone else say that at their core trading and investing really aren't any different. It's all about identifying good candidates and executing the transactions.

I would slightly contest the suggestion that it's timeframe which differentiates the two, though. A lot of people do hold that out as the defining factor, and there's some truth to it in general terms. I look at it a little differently. To me traders, regardless of the holding period involved (since some traders do hold positions for as long as folks we would consider investors), tend to go into a position with at least a basic set of exit criteria. For example, a trader would have a price target or some technical determinent as to when the move they are playing is over. An investor, though, thinks in terms of returns and will hold a position for as long as he/she expects to see the returns they seek.

That's just one of many ways to look at it, though.