“Calling someone who trades actively an investor is like calling someone who repeatedly engages in one-night stands a romantic.“ – W. Buffett
Mr. Buffett has a way with words, doesn’t he? He also makes an important point to anyone contemplating entering the stock market. Know yourself first.
Everyday people with average funds, average intelligence, above average hopes, and probably below average fears, want to get into the stock market. They just want to make money, ideally without losing any and they are aware of the risk.
Most people attracted to the market are aware of one of two ways to participate. They know about buying low to sell high, also known as buy and hold; and they know about day trading. The two are similar but vastly different in analytical methodology, time, strategies, as well as different human character types that tend to participate in each.
Let me clarify something that people get hung up on about the distinction that Mr. Buffett points out: whether investing or trading, you are speculating. What we’re really talking about, in my opinion, is a matter of degree.
Speculation is trading in an asset that has a risk of losing some, most, or all of one’s initial outlay. The objective is always a substantial gain. You would not take a speculative risk if you were looking for the same return you can get in a bank certificate of deposit.
While trading or speculation is mistakenly compared with gambling, a key difference is that speculation is equal to taking a calculated risk and is not dependent on pure chance. Plus, you can always exit the position anytime. Gambling depends on chance or random outcomes; and try taking your bet off a casino table.
Most people would not consider real estate investing as speculation. Review your paperwork from your last purchase. Show me the line in your contract that says your house will appreciate a guaranteed percentage every year. Having said that, isn’t there a term known as “spec homes” in the real estate industry? I mean, it does stand for speculative after all. Hmm, go figure.
In the stock market, if I buy a blue chip stock like IBM in 1998 and sell it in 2007, that is a trade, a buy and a sell. If I buy IBM at 9:45 AM and sell it later the same day, say at 1:45 PM, that is a trade, a buy and a sell. The fact that one was long-term, presumably a buy and hold investment, and the other a short-term day trade is immaterial.
In both situations I have no guarantee of a substantial return. I have a risk. I may have taken steps to hedge my risk, but all the ingredients of speculation are there whether long or short-term trading.
The major distinctions between Warren Buffett’s “investor” and his “active trader” are:
- Investors do think long-term. That could be holding from one quarter to the next or could be years worth of business cycles.
- Traders think in terms of minutes to days. Their sole criteria for a trade is a potential for price movement with room to run.
- Investors think in terms of quarterly improvements in earnings, cost control, cash flow, sales, management, and outlook.
- Traders think the charts already reflect what investors think and thus believe they can see price patterns (behavior) in the charts.
- Is it safe to say traders are impatient vs. investors? My experience says yes, we are an impatient lot.
As far as I know, traders and investors make the best romantics.