Investing vs Trading
These 2 terms stand to be the most commonly misunderstood in the world of finance. Some people think they are both an investor and trader; and there are some who think that they are doing investments while in actual fact they are trading or vice versa.
The main difference between investing and trading is the perspective and the time frame of the action. Investing is similar to staying vested with a company, in hope to be part of their future growth while trading is mainly looking to take advantage of the differences in the entry & exit price with no intention of being vested. Time frame for investment is usually long with no definite exit plan, while trading is largely shorter term with a definite entry/exit plan.
A well-known investor we all know is Warren Buffet. He looks for companies that has an economic moat, and is presumably to be undervalued at current juncture and has the capacity of realizing their potential in the long run. His investments also have long term growth prospect and a sustainable business model. He profits from his investments by having a share of their profits and/or cash flow from his investment via preferred shares.
He also profits from capital appreciation in the stock price on paper and the dividends payable to him. He never sells off his investments until there is opportunity costs levied on them, or when the companies he invests in are no longer economically viable. For example, Buffet divested out of Exxon and increased his stake in IBM.
A trader on the other hand, doesn’t really care about what the company is about and pays little attention to the fundamentals or the long-term prospect of the business. He is always on the lookout for news that is going to affect the price expectations in the short run, or technical patterns that act like a self-fulfilling prophecy. He preys on the temporary chaos or mis-pricing in the dynamic market he is trading.
The trader is also bi-directional and comes in the form of a bull and a bear. He spots the edge in the market by the path of least resistance and executes his position guided by a game plan that seeks prudent financial management. In other words, he is not much different from a professional gambler who plies his trade preying on the probability and sound financial management in the casino.
A trader may also adopt varying time frames for his trades, ranging from minutes to weeks. He also uses instruments that are perceived to be high risk such as options or futures but eliminate these risk through sound financial management. He doesn’t seek to hold on to consolidating stocks over a long period as he needs to maximize the returns of his funds. A typical example of a trader is those working in the prop shops, hedge funds, or those “floor traders” of the past on the exchange floor. They trade the instruments and profit quickly from the difference in the entry and exit prices.
So, are you a trader or investor?
Investor vs Trader
A fantastic investor generates average of 20-30% returns a year. The percentage gain may sound staggering, however if you do not have substantial amount of capital to invest in, this 20-30% a year may not be so good after all. For example, an average joe that has $50,000 of investment funds, generating 20-30% a year would land him between $10,000-$15,000 profits per year.
However, this average joe is not Warren Buffet who has billions of dollars at his disposal, and this average joe certainly cannot generate such excess returns most of the time. An average investor, who peg his returns to the index, is prudently expected to make 5-10% a year. So, scaling the percentage down, his profits would just be $2,500-$5,000 a year.
In absolute terms, this is not enough make up an income enough to sustain their lifestyle. This has yet to consider the fact that a huge portion of an investor’s fund will be locked up in order to generate this return.
On the other hand, a trader boasts of an insane percentage returns annually. Some proprietary traders claim to have xxx% annually, while some hedge fund traders claim to return xx% consistently. A trader manages his funds similar to how a project manager would manage his resources. The manager would deploy his workers or funds to projects that his company committed to. Similarly, a trader would deploy his funds to different markets, using different instruments. Leveraged instruments such as Options or Futures allows the trader to generate a good percentage return to his portfolio. As his trading frequency is high, he is also more susceptible to short term losses. Therefore, prudent financial management is a must.
Most retail investors secretly want to be a trader as the lure of thrill and money is too great to reject. Seeing how some traders rake in thousands in a single trade, make them wonder why they are working so hard only to earn that same amount in their monthly paycheck. Sub-consciously they want to be able to embark on a financial free life and to be free from their job. But, do they have what it takes?
What it takes to be a Trader?
It’s the perspective and mindset that separates the professionals and retailers. It’s not by pure luck that 10% of the top performers earn 90% of the money going around in the industry and 90% of the market participants will lose money. These professionals, act and think in a very different manner from the rest of the retailers.
For a start, they have realistic expectations of their returns and acute sensitivity to the market they are trading. Should the market don’t suit their skillset or temperament, they either pass on the trade or switch market entirely. They are also guided by a set of rules that ensure they don’t self-implode or blow their account in a series of trade. Of course, they are the hardened veterans that has the discipline and tenacity to carry out their trading rules.
On the other hand, most retail traders are in for a quick buck.
Myth vs Truth
How much does can a retail trader expect to make? I am sure you have come across many advertisements that hype up trading with statements such as “I made $50,000 in a week!” or “I made what I earn in a month, in merely few hours!”. All these statements certainly hype up the emotions of many people, allowing them to have a false representation of the business. As a result, many people simply pass off trading as gambling, and as a “Get Rich Quick” method.
Undeniably, we hear or see winners every now and then. Our own experience also shows us that landing winning trades that return few folds of your capital is also possible from time to time. But can this feat be repeated on a consistent basis? NO. A trader can get lucky once in a while and his positions returned way better and faster than expected. But what about the vast majority of losers that we never get to hear or meet? After all, people only publicize their “highlight reel” on social media, isn’t it?
The staggering fact is 90% of the people WILL lose money in the market and only a small 10% would be profitable in the long run. For most retailers with no formal education in finance or some form of education in finance, it’s simply not realistic to expect themselves to outdo a professional that has been through the best training in the business before attaining their success.
Most retail traders take a weekend course, or a month-long course and they expect themselves to be as good as the professionals. Let us look at this from this angle; If a weekend crash course is sufficient, then why the professional traders usually need to make it through years of top notch university education and a further additional years of apprenticeship under the best mentors in this business? Despite so, some of these professional traders still lost money. So, what have a retail trader done right to outdo or outwit these professionals?
How Much Does A Trader Need?
Warren Buffet returns an average of 24% annually. Let us be bold to assume a retail trader can be as good as Buffet and returns 2% a month. Then working backwards, how much capital would we need to make our target income a month?
To make $1,000 a month, you would need a capital of $50,000.
To make $5,000 a month, you would need a capital of $250,000.
To make $10,000 a month, you would need a capital of $500,000.
Well, you get the picture here. Wanting to make $3,000 monthly immediately to replace your existing income with a starting capital of $5,000 is simply not realistic for a developing trader. Yet in my encounter with many aspiring traders paints this naivety.
Some great traders claim they are able to achieve 10% returns on a monthly basis. Giving them the benefit of the doubt, let us see how much capital they would need.
To make $1,000 a month, you would need a capital of $10,000.
To make $5,000 a month, you would need a capital of $50,000.
To make $10,000 a month, you would need a capital of $100,000.
Most of the new entrants to this business are only willing to start with $5,000 – $25,000 of their disposable income/savings. With this sum in mind, even if they are able to return a rate of 10% per month, it’s highly unlikely that they would earn close to what their current monthly income is. Going by my experience, trading with an account as small as $5000 is similar to driving with hands taped to the steering wheel fixed at the 10&2 o’clock position.
Without proper financial education & skills, there is little way a retail trader is able crave a living out of the financial market. Preserving capital would be the greatest challenge a retail trader would face in his developing phase, let alone making gains.
Instead of aiming for “elephant trades” that wins multi-fold, a realistic approach would be to aim for achievable returns consistently starting with $50 a day (especially for a small account of $5,000). Citing from basketball’s analogy, it’s not about making the half-court shot but to score every free throw that was awarded.
Truth of Trading
Is trading actually as easy or as glamorous as advertised? No, it’s not. Before a trader can dream of making $10,000 a month, he must first learn how to secure $100 profits every day. There is more to just knowledge on trading such as FA and TA. You need to have something extra, an edge over the mass market.
Putting the numbers in perspective; if a trader starts with $5,000 to trade, 2% monthly returns would earn you $100 a month. Assuming he makes 2% consistently for the rest of the year, he would have gained $1,200 before transaction costs. Not bad for a $5,000 account!
Losers vs Winners
How did winners become winners? They must have done something differently from the losers, that allows them to have an edge over the rest. It simply boils down to their values;
Patience, Dedication, Discipline & Passion
Is the trader willing to stay up late to observe the market while his peers or family enjoy leisure time? Is the trader willing to forgo his own leisure time during weekends so that he is able to do research and plan for the trade in the coming week? Then is the trader willing to put his skills to the test by paper trading with the purpose of learning and improving but not making money for the effort?
What is best, is that is the trader willing to do all these without the guarantee that he will eventually become profitable and successful as a trader some time down the road? All the effort and work may be done in vain even though it possesses the potential to propel the trader towards the lifestyle he envisions.
Now that you know about the hard truths of trading for a living, do you have what it takes to become one?
Write to me here, I would love to hear your views…