Some people like to invest. ("Hey, I just invested $5,000 in this great new biotech company!") Other people seem to like to trade. ("Yeah, well, I just bought 1,000 calls on the same company because they’re announcing earnings tomorrow!") This raises some interesting questions. Is there really a difference between investing and trading? And, if so, what is different about these two seemingly similar pursuits? Let's ask the questions:
Question: Is there a difference between “investing” and “trading”?
Answer: Technically, this is simply a matter of semantics. For my own purposes, however, there is a difference. I define “investing” as putting money into some specific approach for an extended period of time to achieve an above-average, long-term rate of growth. I define “trading” as speculating on short-term changes in price. So, by virtue of these definitions, I make a distinction between investing and trading. An individual can participate in both endeavors. However, what is most important to note is that you need a different mindset for each.
Question: What is the primary difference between an investor’s mindset and a trader’s mindset?
Answer: Both pursuits require discipline; however, the disciplines required are often quite different. The most notable difference is that, in order to be successful:
- A trader must generally be quick to react
- An investor generally needs to be slow to react
A trader must have the discipline to pull the trigger without wavering -- whether it means cutting a loss, snapping up a profit or entering a new trade after the last three trades have been losses. An investor must often do just the opposite. That is, at times, he must avoid pulling the trigger just because a position is presently showing a loss or a quick windfall profit.
Some individuals easily adopt one mindset or the other because it simply works best for them, given their own personality and emotional make-up. As a result, some people are totally immersed in the market from day to day, buying, selling, shorting, covering, taking profits, cutting losses, and so forth, on an ongoing basis. On the far end of the spectrum are people who put money into mutual funds and never sell them. They just keep putting money in until they retire or otherwise need the money. And, of course, there is everything in between.
If you listen to the people at one end of the spectrum or the other, they will often tell you that their way is “the best” way. However, as I have mentioned in the past, whenever someone tells you, “In order for you to be successful, you must…,” what the person really should be saying is, “In order for me to be successful, I must…” What you must do to succeed may be completely different. The key, then, is to determine correctly where you fit in along the “investor / trader” spectrum.
Question: Do I have to choose between being an investor or a trader?
Answer: No. It does not necessarily need to be an either / or proposition. It is perfectly acceptable to buy a mutual fund and hold it forever, all the while buying and selling options along the way. Here's how people get into trouble: They start out with the idea of buying a fund and holding it forever, all the while trading options along the way, but end up trading in and out of the mutual fund and / or holding their option trades way too long. In other words, it’s okay to invest, and it’s okay to trade, but it’s not okay to treat your long-term investments like trades or your short-term trades like investments.
Question: How’s the market doing?
Answer: If only we had a dollar for every time someone asked that question. We wouldn’t need to worry about the stock market anymore, now would we? Yet, every time the question is asked, we seem to hear a different answer. For us avid stock market followers, when the market is up, we feel optimistic, and when the market is down, we feel pessimistic.
This can happen from one day to the next and then back again if we let it (which explains why sentiment indicators can be so useful at times). If only we could somehow get a handle on the bigger picture. For most of us, it is much easier to make investment decisions if we feel that we have a handle on the major trend of the market. So, how does one “get a handle” on the major trend of the market?
A model I have written about before looks at percentage price swings for the Russell 2000, the OTC Composite and the S&P 500. The model I want to discuss in this article is similar, but also different. This one looks at the price swings for the three major Dow averages: The Industrials (IN DU), the Transports (TRAN) and the Utilities (UTIL). Before getting into the details, let’s first discuss what this method is intended to do -- and not intended to do.
This model is intended to tell us whether the current overall trend of the stock market is up or down. However, it is not intended to, nor should it be expected to, pick tops and bottoms. In other words, it will miss some of the rally off the bottom, and it will sell after the top. But, the tradeoff is that it will generally be “on board” for “the meat” of most major bull markets and, just as importantly, will be on the sidelines during the worst of most serious bear markets.
In a nutshell, just because this model is bullish today does not mean the market will move higher in the days or weeks ahead. Likewise, a bearish indication today does not necessarily imply impending doom. The sole purpose of this model is to provide an objective signpost, with no attached expectations of perfection.
Here’s how it works:
- A buy signal occurs when the Dow Industrial Average is 5.5% above its most recent low and the Dow Transports are 6% above their most recent low and the Dow Utilities are 2% above their most recent low.
- A sell signal occurs when the Dow Industrial Average is 5.5% below its most recent high and the Dow Transports are 6% below their most recent high and the Dow Utilities are 2% below their most recent high.
That’s all there is to it. For testing purposes, I looked at the period from June 1986 through January 2005. I used the Dow Industrial Average and assumed that trades would be done at the close on the day after the signal occurred. So, if a buy signal occurred after the close on Monday, a long position would be entered at Tuesday’s close.
Question: So how has this simple method performed?
Answer: In the long run, very well. Overall, this approach handily outperformed a buy-and-hold approach. As expected, this system has tended to underperform during strong bull markets and strongly outperform during major bear markets. Figure 1 displays the growth of $1,000 using both the system (blue line) and a buy-and-hold approach (purple line).
Figure 1
Growth of $1,000 for This System (blue)
versus the Buy-and-Hold Approach (purple) since 1986
As you can see in Figure 1, the system enjoyed not only greater profitability, but also a more consistent return. $1,000 invested in the Dow in June of 1986 would have grown to $5,654. At the same time, $1,000 invested according to the rules described previously would have grown to $8,826 (this does not include any interest that would have been earned while out of the market).
Figure 2 shows the drawdowns experienced by both the system and the buy-and-hold approach since 1986. Since that time, the Dow has had two declines greater than 35% -- one was the 1987 Crash and the other occurred during the 2000 - 2002 bear market. These punishing declines are visible on the left and right sides of Figure 2.
The maximum decline in equity for the buy-and-hold approach was -37.8%. The worst decline suffered by the system was -22.2%. Although a 22% decline is no small matter, this method suffered a lot less on the downside than the buy-and-hold approach.
Figure 2
Maximum % Drawdown for This System (blue)
and the Buy-and-Hold Approach (purple)
Table 1 shows the year-by-year results of the system versus a buy-and-hold approach. What is interesting to note is that the system only outperformed the buy-and-hold approach during 5 calendar years of the 18 calendar years covered in this test. During 7 of the years, it underperformed and, in 6 years, it performed the same as the buy-and-hold approach.
The key is simply that, in most cases, when the system outperformed the buy-and-hold approach, it did so by a wide margin. Most notably, the system missed the 1987 Crash and most of the 2001 and 2002 declines. Between 2001 and 2002, the system actually made 21.3% while the Dow lost more than 22%.
Year |
System
% +/- |
Buy-and-Hold
% +/- |
System vs.
Buy-and-Hold |
1987 |
34.6 |
2.3 |
32.3 |
1988 |
9.3 |
11.8 |
(-2.5) |
1989 |
27.0 |
27.0 |
0.0 |
1990 |
(-0.7) |
(-4.3) |
3.6 |
1991 |
20.3 |
20.3 |
0.0 |
1992 |
4.2 |
4.2 |
0.0 |
1993 |
13.7 |
13.7 |
0.0 |
1994 |
(-2.3) |
2.1 |
(-4.4) |
1995 |
33.5 |
33.5 |
0.0 |
1996 |
15.9 |
26.0 |
(-10.1) |
1997 |
22.6 |
22.6 |
0.0 |
1998 |
15.8 |
16.1 |
(-0.3) |
1999 |
16.2 |
18.5 |
(-2.3) |
2000 |
(-7.0) |
(-0.8) |
(-6.2) |
2001 |
14.3 |
(-7.1) |
21.4 |
2002 |
6.2 |
(-16.8) |
22.9 |
2003 |
28.0 |
25.3 |
2.7 |
2004 |
(-1.0) |
3.1 |
(-4.2) |
Table 1
Annual Results of This System versus the Buy-and-Hold Approach
A System That Delivers on Its Promise
No one will argue that this is the “greatest world-beater” system ever developed. But, then again, no one claimed that it would be. What the performance of this system does point out is that it is possible to accumulate wealth using a simple, non-aggressive approach to investing. Individuals should engage in a variety of investment and trading methods that offer the potential for generating great wealth. But, for an investor looking to establish a “core” investment position, this simple system offers many advantages.
|
|
