“Trader or Investor”

Are you an investor or a trader? The answer is I don’t know exactly where one begins and the other one ends. This question needs to be examined because it provides insight into why so many people would be far better off investing in a diversified portfolio of low cost passive investments such as low cost mutual funds and exchange traded funds that they rebalance periodically or systematically.

We learned in that the single most important concept about diversification isn’t whether it is good or not, it is whether you should do it or not. We learned in that you can increase your rate of return by approximately 1% per year while reducing your risk if you systematically rebalance your portfolio and choose a balanced allocation to stocks and bonds. We learned in that trading is a zero sum game. We learned that in order for a trader to win it must come at the expense of another trader or traders. We also learned that to be a winning trader you must have a trading approach with a positive mathematical expectation. If you don’t you will be a losing trader. It’s clear then that people trade because they think they can make money from inferior traders. Otherwise they wouldn’t unless of course they just enjoy losing money. Lastly, we learned in that you must develop your own methodology or you will be unsuccessful since every day in the investment world is today.

This tale tries to bring some clarity to the question of investing. What about investing? Is it a zero sum game? For example, the individual that purchased General Electric 30 years ago and has never sold a share had to purchase it from someone. Is the purchaser a trader or an investor? Assuming that General Electric went up during the 30-year period did the purchaser make money at the expense of the seller? Is the person that sold it to him 30 years ago a trader or an investor? What about when after 30 years of holding General Electric the original purchases decides to sell it? This is the complexity of the question are you a trader or an investor?

In order to get a handle on this question let’s develop an extreme scenario. Let’s imagine a world that allows stock investing but with no stock trading allowed. In this world everyone is an investor. There are no traders. If you buy a stock you would purchase it directly from the issuing company using a formula that everyone agrees is the correct way to value the stock you are purchasing. Similarly, when you go to sell you would sell it back to the company using the exact same formula. In this imaginary world the price you sell your shares for compared to the price you bought them for would be your profit or loss. In this world you would fall under one of the many definitions of an investor as one that buys small pieces of a business. These small pieces of a business are stocks of course. For the sake of simplicity let’s say the holding period in this world is 30 years.

What would this world look like in terms of rate of return on stocks? We know that historically stocks have returned about 9-10% per year to investors over the last 75 years or so. Let’s assume that the rate for the next 30 years would be 10%. This is a reasonable assumption. In the world that I created not everyone would earn a 10% return but in the aggregate the sum total of all investors would earn 10%. Those that construct a diversified portfolio of these non-tradable stocks would all cluster around this 10% return area and those that construct concentrated portfolios would have the possibility of deviating significantly from the 10% area. These concentrated portfolios could even have negative returns if the person making the investment decisions wasn’t particularly talented at securities selection. Others that build these concentrated portfolios might make returns in excess of 20% since they have superior stock selection skills and will invest in those companies that will based on the formula make the most return. I use the term securities selection to highlight superior stock picking skill. Stock picking skill is not the same as trading. Trading is a different skill.

Please note that in my imaginary world, like the real world, and with academic research, the possibility of someone constructing a diversified portfolio of stocks that significantly deviates from the 10% average does not exist. Why do I say this? It’s by definition. If you have a diversified portfolio you will make market rates of return which in this case are 10%. If you examine the record of people that have achieved great rates of return you will discover people that have some combination of a concentrated portfolio or superior trading. Great performance does not come from someone that builds a diversified portfolio of stocks they buy and hold. Some may argue with this but don’t believe them, by definition it is not true. Again this doesn’t argue against diversification it just points out its limitations. If you have superior stock picking skill you should use it, why settle for diversification rates of return. If you don’t you should diversify because the superior stock selectors in this case is taking a large chunk of your money as well as little chunks of all the diversified investor’s money.

What can we learn about this imaginary world so far? We can learn that investing, unlike trading, is a non zero sum game or endeavor because the pool of wealth grows at 10% per year on average. In a zero sum game the pool would grow at 0% per year on average. Investing in stocks has based on history a 10% gain built in so stock investing is a positive sum game. This is a very good thing and something that people looking to build wealth should take advantage of. What else can we learn? We learned that there are different levels of stock selection expertise. We can measure this expertise against the 10% benchmark. There are those that will lose money in this world and those that will amass great wealth strictly on their stock selection skills.

Let’s introduce trading into the positive sum game of investing. In other words let’s introduce a zero sum game into a positive sum world. In my imaginary world, investors show up to the investing game with a built in 10% rate of return if they choose to diversify. If they choose to concentrate they may make more or less than 10% but the winner must possess superior stock picking skill. But what if they choose to act like traders? Let’s now define the two terms. The investor doesn’t make any transactions, trades or switches during the 30-year period. The trader does. So the trader must make these trades with other traders. Since the trader must also trade something they are by default also stock selectors. Trading thus means switching stocks during this 30-year period with the intention of beating the “investment return” of 10%.

We now have a world where a player can choose to diversify and make approximately 10% per year. They can choose to concentrate and hopefully make more than 10% if they possess superior stock selection skills. Lastly, they can trade with other like minded people that think they possess superior stock trading skills. Keep in mind since the total pot in this game can’t exceed the 10%, then the superior players, those that make more than 10%, must be either superior stock pickers or superior traders or both. In addition the superior players have made a conscious decision to not diversify and settle for a 10% return. To complete the logic, it’s possible for someone to possess superior skills in either stock selection or trading and still make less than the 10% return than those that choose to not play the game by simply diversifying. How can this be? It is possible for someone to possess one of the superior skills but be so deficient in the other so as to produce a less than 10% outcome.

In this tale I have just explained the stock investing game. It’s a game that has a positive outcome with only three types of players. There is the diversifier, the trader and the stock selector. All three are known as investors yet they are unique. Traders and stock selectors think they can do better than the diversifiers because otherwise they wouldn’t be trading or stock selecting. The diversifier comes in two forms. The first chooses to diversify out of ignorance since they have heard that it is the only way to invest if you don’t know what you are doing. The second has researched the markets through study or trial end error and has reached the conclusion that they don’t possess either superior trading skills or superior stock selection skills and is happy with a diversified portfolio and makes 10%. Either way it doesn’t matter. Both choose to diversify but for different reasons. Once again, this is why diversification is called the only free lunch on Wall Street.

So what should you be? The reality is that very few people possess superior stock selection skill and in my opinion even less people possess superior trading skills. For the vast majority of investors they are better off in a diversified portfolio of stocks in the form of low cost stock index funds and exchange traded funds. When you consider that trading is a zero sum game but that in the world there are real trading costs, we see that the chances of success for all but the truly gifted are even more remote. Trading isn’t a zero sum game as it is in my imaginary world in reality it is a negative sum game because of trading costs.

So have we answered the question of identity? Can we tell what an investor is vs. a trader? I think the answer is unclear. Like so many things it is a state of mind. You are what you define yourself to be. In our example an investor was one that held a portfolio for the 30 years without making any switches. The trader is one that during this 30-year period made a switch with another trader in order to try to exceed the 10% return that is readily available through diversification. But what if we lowered the holding period from 30 years to 30 months or 30 days or 30 minutes and used the same logic? Would we still be able to classify people as investors or traders during this shorter holding period? The answer is yes in a theoretical sense. In a practical sense it is not. In my opinion everyone that invests is a little bit of each. Call yourself whatever you want, just make sure you know that if you choose to play the stock selection or trading game that you are giving up an expected 10% rate of return in exchange for more or less depending on your skill.

Financial Tales has been promoting Financial Literacy since September 29, 2008. If this tale has contributed to your financial education, financial literacy and/or financial freedom, subscribe and share Financial Tales with friends and family who will benefit from the lessons. If you have any questions/comments/compliments, drop me a note. Thank you.

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