Wednesday, January 2, 2008

Investing vs. Trading, a Slippery Slope

Most commentators agree that people should be investors rather than traders. However, it’s impossible to be an investor without trading sometimes (or at least once). This is like telling people not to become smokers, but expecting them to take a puff once in a while.

Let me start by explaining what I mean by “trader” and “investor.”

A trader is someone who buys and sells stock. We usually use the term “trader” to mean those who trade stocks frequently and base their decisions on recent stock price movements rather than the health and future prospects of the businesses behind the stocks.

An investor is someone who examines businesses to try to predict their long term success in terms of revenues and profits. Some commentators stop there, and I know what they mean, but none of this analysis makes any difference unless you actually buy the stock. Investors have to be traders at least part of the time.

Let’s say that you are an investor who has found a business you would like to own because its long-term prospects look excellent. But that’s not enough to justify buying the stock. You can’t just ignore the stock market and focus exclusively on the businesses. You need to have an opinion on a fair price for the stock and compare this to the stock’s current price.

Suppose that you find a good business available at a bargain price. Now, you have to start thinking like a trader. Should you just place a market order for the stock, or should you protect yourself with a limit order? What price are you willing to pay?

Fortunately, investors who focus on businesses don’t have to become traders very often because they tend to hold stocks for long periods of time. In contrast, traders tend to pay a high price in commissions and spreads because they trade in an out of stocks far too frequently.

Even people with the best of intentions to be investors will feel the excitement (or terror!) when they put money at risk by placing a trade order. This excitement can be seductive. It’s also more interesting conversation to talk about the possibilities of short-term gains from trading stocks than it is to talk about whether some company will have good product sales over the next five years.

Unfortunately, because brokerages make money from commissions on trading, many of them encourage their clients to be traders rather than investors. The world of stock trading can be seductive, and when you’re forced to take a puff, don’t get hooked.

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