Over the weekend I was browsing through twitter and someone had posted a Warren Buffets quote
where he says that “calling someone who trades actively in the market an investor
“is like calling someone who repeatedly engages in one-night stands a romantic.” And this got me
thinking about why people differentiate so much between Trading and Investing.
After all the people involved are just trying (with varying degrees of success)
to earn the best return they can on their capital. If you reach for the dictionary, you’ll see
investing defined as “buying something in the hope of making a profit or a return”.
That is exactly what a trader does – and outside of the stock market - it is what most retailers
and manufacturers of goods do. You’ll notice that no one is encouraging Walmart to hold on
to their inventory for longer than necessary. So, what is the difference between trading and
investing? Is one better than the other, and does it make sense to discourage short term trading?
Well, the online consensus appears to be that investors are people who build diversified
portfolios of assets and stay in them through the ups and downs of the market seeking a larger
return over an extended period of time. They do this through buying and holding. Traders,
on the other hand, take advantage of both rising and falling markets entering and exiting positions
over a shorter time frame, hoping to earn quick returns based on short-term market moves.
These are clearly quite different approaches, but why is it argued that one approach is better
than the other? The Buffett quote even implies that there is possibly something less wholesome
about short term profits. Most governments seem to agree with that point of view and discourage short
term trading, by setting a higher tax rate on short term capital gains versus long term gains.
One of the first arguments I found comparing the two approaches put forth that investors do more
analysis than traders do. Long term investors generally build DCF models and attempt to
calculate the intrinsic value of a company. They assess the competitive advantage of the business
and the quality of management. By contrast traders pay no attention to any of this stuff
and usually trade based upon chart patterns – known as technical analysis.
This argument unfortunately shows a complete misunderstanding of what traders actually do.
While traders may not try to calculate the fundamental value of a company, it is worth
noting that there is limited evidence that that such calculations have any real predictive power.
(now these are useful calculations for a variety of other reasons in finance,
but this is not the only style of research that can be done) Most successful traders spend all
of their working day doing analysis – it is just a different style of analysis. And this is
because most trading strategies aim to profit from pricing anomalies that can be found in markets,
that usually require specialized knowledge. So, some examples of the strategies that
traders might specialize in are things like merger arbitrage, where one company has agreed to buy
another, and the trader has expertise in assessing the probability that the deal will close.
Often, these traders have a background in M&A or in securities law, they’ll know a lot about
the industries that they cover and they’ll have a good understanding of things like antitrust law.
Convertible bond arbitrage is another trading strategy, where the trader identifies mispricing
between the option embedded in a convertible bond and the fair value of such an option.
Statistical arbitrage is a strategy that takes advantage of price distortions caused by large
buy and sell orders being executed in the market – it is one of the core strategies at Renaissance
Capital – one of the most successful funds in history. Distressed debt investing is a strategy
that tries to profit from market imbalances caused by certain investors being prohibited from holding
debt securities below a certain grade. Event driven, involves trading the securities of
companies undergoing corporate events like M&A spin offs restructurings and bankruptcies where
specialist traders understand how these events can make price changes more predictable than
under normal circumstances. I have spent most of my career building quantitative models that make
short term predictions of price changes in various futures contracts. Without belaboring the point,
hopefully you can see that very few traders rely on just instincts and chart patterns.
The truth is that I’ve never met a good trader that could be described as lazy.
So next up, is there a social good associated with buy and hold investments when contrasted with
short term trading? I don’t believe there is. Most short-term trading strategies make markets more
efficient, ensuring that all investors get a fair price when they buy and sell financial securities.
For example, if companies are issuing convertible bonds too cheap, traders will step in and compete
to buy that bond pushing the price closer to fair value. If a big investor is selling their Coca
Cola shares, there is a chance that a statistical arbitrage trader is buying these shares
and hedging the trade with a short position in Pepsi. This means that the big investor is more
likely to get a good price on their sale. Short term traders make market prices more efficient on
a day-to-day basis, which provides a social good. A good way of thinking about how markets work is
that if a commodity is in short supply, traders’ step in, hoping to profit by buying the scarce
good. These purchases will push up the price, thereby reducing consumption of that commodity
so that the available supply might last a bit longer. Producers see these higher prices and
are encouraged to produce or import more of the good. Equally, in other situations where
the price is higher than the speculators think is reasonable, they sell. This reduces prices,
encouraging consumption and helps to reduce surpluses in the economy.
Traders through their actions ensure that producers all over the world will
provide the required quantity and quality of goods at the right time, minimizing waste.
This mechanism provides the goods that people want at prices that they can afford.
Now, traders are not always right in their predictions,
and when they are wrong, they can contribute to price bubbles, panics, or even crashes. But the
same can be said for long term investors too. Are there any other advantages associated with
trading rather than long term investing? Well, an investor might want some exposure in their
portfolio to the returns of a given trading strategy, simply because most of the returns
available to long term investors are largely dependent on the overall market direction,
while the returns of a given trading strategy should relate more to the quality of analysis,
and the amount of opportunity available in a market at a given time.
Another argument I often hear is that traders are just gamblers. Does this argument have
any validity? Well, it is true that there are short-term traders who are just seeking the thrill
of a gamble, in fact when most sporting events were cancelled last year due to the pandemic,
many gamblers began trading stocks and cryptocurrencies – possibly to alleviate
the boredom of lockdown. A key difference between trading and gambling though - is
that the risk in gambling is specifically created by a casino for entertainment purposes while the
risk of trading is a risk that is inherent in all economic activity. I do agree that a gambler is
probably more likely to be attracted to active trading than long term buy and hold investing.
So, do I think that everyone should give up long-term investing in favor of trading?
Absolutely not. There are many pitfalls in trading that long term investors avoid.
First up is transaction costs. When you are buying and selling a lot, what can initially look like
tiny transaction costs can start to really add up. A lot of retail traders tell me that they pay no
transaction costs by using a commission free broker. There is however a fee, that doesn’t
show up on your brokerage statement, the “spread” which is the difference between the price you pay
to buy a stock and the amount you’d receive if you sold it. This can be thought of as being like the
house take in a casino. The spread can be as low as 0.02% in the most liquid stocks and as high as
8% in microcap stocks. Let’s say you are an active trader who turns over their portfolio once a day
in the most liquid stocks. In a year you would have lost 10% or more to transaction costs.
That drag on your returns is as much as a buy and hold investor might expect to make in a year.
The worse your broker is, the more of a drag you will have on your returns, if you are trading
penny stocks, this drag will be massive. For this reason, most professional traders aim
to trade as little as they can get away with. They realize that they are swimming upstream.
Possibly the biggest advantage of being a long-term investor is that you get significantly
better tax treatment. Not only are long term investors taxed at the lower long term capital
gains tax rate, but they are only taxed when they sell their stocks. Many wealthy investors
never sell their stocks, they just borrow against their investment portfolio for living expenses.
They don’t pay capital gains taxes and they don’t push their taxable income into a higher tax
bracket either. I suspect that the main reason Buffett never sells stocks relates more to tax
efficiency than anything else. There is no reason to believe that because he felt that a stock was
cheap 40 years ago, it is still cheap today. He is simply managing his money in the most tax
efficient manner – which is what the government must want you to do, as they set the tax rules.
Now, the final disadvantage of being a trader is that it usually consumes pretty much all of your
time. You are involved in a very competitive activity, and most people who do it are a bit
obsessed and devote their time to it because they find it both interesting and challenging.
Long term investors on the other hand can work a full-time job and spend a few hours a year
investing their savings. Even for those with enough capital to not need a steady paycheck,
they may not want to spend all of their time at a computer researching trading strategies.
So back to the Warren Buffett quote. Can you call a trader an investor? In my opinion yes, they
are managing their money to grow their wealth. I would add that not only is a trader an investor,
but Warren Buffett is himself a trader, often trading derivatives, getting involved in merger
arbitrage, and other special situations trades. The Economist Henry Crosby Emery describes
speculation as the struggle of well-equipped intelligence against the rough powers of chance.
An activity that almost every economically active person is involved in, whether they
want to be or not. Victor Niederhoffer in a Wall Street Journal article titled “The Speculator as
Hero” argued that speculators who apply their intelligence to predict tomorrow’s prices today
are an indispensable component of all societies. By buying low and selling high, they bring about
market efficiency creating harmony and freedom. For those of you interested in learning more about
trading strategies and how traders invest, check out my video on the top ten books for
traders at this link. See you later. bye