Can We Please Get This One Basic Thing Right?

Pop-quiz, people – how many of us know the basic difference between investing and trading?

The logical follow-up question would be – why is it so important that one is aware of this difference?

When you buy into deep value cheaply, you are investing. Your idea is to sell high, after everyone else discovers the value which you saw, and acted upon, before everyone.

When you’re not getting deep value, and you still buy – high – you are trading. Your idea is to sell even higher, to the next idiot standing, and to get out before becoming the last pig holding the red-hot scrip, which would by now have become so hot, that no one else would want to take it off you.

The above two paras need to be understood thoroughly.

Why?

So that you don’t get confused while managing a long-term portfolio. Many of us actually start trading with it. Mistake.

Also, so that you don’t start treating your trades as investments. Even bigger mistake.

You see, investing and trading both involve diametrically opposite strategies. What’s good for the goose is poison for the gander. And vice-versa.

For example, while trading, you do not average down. Period. Averaging down in a trade is like committing hara-kiri. What if the scrip goes down further? How big a notional loss will you sit upon, as a trader? Don’t ignore the mental tension being caused. The thumb rule is, that a scrip can refuse to turn in your direction longer than you can remain solvent, so if you’re leveraged, get the hell out even faster. If you’re not leveraged, still get the hell out and put the money pulled out into a new trade. Have some stamina left for the new trade. Don’t subject yourself to anguish by sitting on a huge notional loss. Just move to the next trade. Something or the other will move in your direction.

On the other hand, a seasoned investor has no problems averaging down. He or she has researched his or her scrip well, is seeing  deep-value as clearly as anything, is acting with long-term conviction, and is following a staggered buying strategy. If on the second, third or fourth buy the stock is available cheaper, the seasoned investor will feel that he or she is getting the stock at an even bigger discount, and will go for it.

Then, you invest with money you don’t need for the next two to three years. If you don’t have funds to spare for so long, you don’t invest …

… but nobody’s going to stop you from trading with funds you don’t need for the next two to three months. Of course you’re trading with a strict stop-loss with a clear-cut numerical value. Furthermore, you’ve also set your bail-out level. If your total loss exceeds a certain percentage, you’re absolutely gonna stop trading for the next two to three months, and are probably gonna get an extra part-time job to earn back the lost funds, so that your financial planning for the coming months doesn’t go awry. Yeah, while trading, you’ve got your worst-case strategies sorted out.

The investor doesn’t look at a stop-loss number. He or she is happy if he or she continues to see deep-value, or even value. When the investor fails to see value, it’s like a bail-out signal, and the investor exits. For example, Mr. Rakesh Jhunjhunwala continues to see growth-based value in Titan Industries at 42 times earnings, and Titan constitutes about 30% of his billion dollar portfolio. On the other hand, Mr. Warren Buffett could well decide to dump Goldman Sachs at 11 – 12 times earnings if he were to consider it over-valued.

Then there’s taxes.

In India, short-term capital gains tax amounts to 15%  of the profits. Losses can be carried forward for eight years, and within that time, they must be written off against profits. As a trader, if you buy stock and then sell it within one year, you must pay short term capital gains tax. Investors have it good here. Long-term capital gains tax is nil (!!). Also, all the dividends you receive are tax-free for you.

Of course we are not going to forget brokerage.

Traders are brokerage-generating dynamos. Investors hardly take a hit here.

What about the paper-work?

An active trader generates lots of paper-work, which means head-aches for the accountant. Of course the accountant must be hired and paid for, and is not going to suffer the headaches for free.

Investing involves much lesser action, and its paper-work can easily be managed on your own, without any head-aches.

Lastly, we come to frame of mind.

Sheer activity knocks the wind out of the average trader. He or she has problems enjoying other portions of life, because stamina is invariably low. Tomorrow is another trading day, and one needs to prepare for it. Mind is full of tension. Sleep is bad. These are some of the pitfalls that the trader has to iron out of his or her life. It is very possible to do so. One can trade and lead a happy family life. This status is not easy to achieve, though, and involves mental training and discipline.

The average investor who is heavily invested can barely sleep too, during a market down-turn. The mind constantly wanders towards the mayhem being inflicted upon the portfolio. An investor needs to learn to buy with margin of safety, which makes sitting possible. An investor needs to learn to sit. The investor should not be more heavily invested than his or her sleep-threshold. The investor’s portfolio should not be on the investor’s mind all day. It is ideal if the investor does not follow the market in real-time. One can be heavily invested and still lead a happy family life, even during a market down-turn, if one has bought with safety and has even saved buying power for such cheaper times. This status is not easy to achieve either. To have cash when cash is king – that’s the name of the game.

I’m not saying that investing is better than trading, or that trading is better than investing.

Discover what’s good for you.

Many do both. I certainly do both.

If you want to do both, make sure you have segregated portfolios.

Your software should be in a position to make you look at only your trading stocks, or only your investing stocks at one time, in one snapshot. You don’t even need separate holding accounts; your desktop software can sort out the segregation for you.

That’s all it takes to do both – proper segregation – on your computer and in your mind.

Advertisements