The Trader vs. The Investor: Two Views of the Market

How do you see the stock market? Clearly there is one thing everyone would agree with: the stock market is a place for building wealth. It's the method for building wealth that varies greatly among those that take part in it.

The fact is that there are two fundamentally very different ways to approach making money in the stock market. For the purposes of this article, we will look at two very different stock market participants: the Trader and the Investor. Both of these guys are looking to make money through the stock market, but their methods vary greatly. Let's compare the outlook, prejudices, and methods of these two participants and then comment:

Criteria or Question	Trader	Investor
What is a stock?	A chance to "play" the market's idiosyncrasies or expected short-term conditions to make a quick buck.	A small piece of ownership in a business.
What is your time frame for holding a stock?	Short-term. As short as a few hours, most common period 3-6 months.	Long-term. At least one year, most common period 2-3 years, sometimes willing to hold indefinitely.
When should you buy a stock?	Decision based on price momentum. Buy near the "support" level for the stock price, which is usually an average low over a period of time. Also, buy stocks that have recently outperformed the market (relative strength).	Buy when the stock price is cheap relative to business metrics such as earnings, sales, book value, or cash flow.
When should you sell a stock?	Sell at the high end of the stock's price range, which is usually an average high over a period of time.	Sell when the stock price is rich relative to business metrics such as earnings, sales, book value, or cash flow.
Motto	"The trend is your friend."	"Buy good companies at cheap prices."
Godfathers	Charles Dow, Ralph Elliott, William Gann	Benjamin Graham, Warren Buffett, Philip Fisher
Disciplines	Technical analysis, behavioral finance, price chart analysis	Fundamental analysis, quantitative/qualitative analysis, accounting
Important Statistics	Moving average, relative strength, support and resistance level, trading volume	Price-to-earnings ratio, price-to-book, price-to-sales, free cash flow, return on invested capital
Proof of Effectiveness	Unclear. Little concrete evidence of systematic market outperformance	Numerous historical studies confirm success of investing based on low price to metric ratios

At MagicDiligence, we follow the Magic Formula Investing strategy devised by successful hedge fund manager Joel Greenblatt in his book The Little Book that Beats the Market. Magic Formula Investing clearly falls under the Investor category above. It uses two fundamental business statistics: earnings yield (the inverse of price-to-earnings) to find cheap stocks, and return on invested capital to find good companies. Combined, the net effect is finding "good companies at cheap prices"... the motto of the Investor. MagicDiligence adds value to Magic Formula Investing by doing deeper fundamental analysis when choosing Top Buy picks, weeding out the companies with sustainable high return on capital figures and throwing out fad stocks, unpredictable commodity stocks, and companies in dying industries.

The last row of the table above illustrates the reason why you should choose the Investor path when building wealth in the stock market. Overwhelming evidence shows that, over the long term, those following the path of the Investor are much more likely to be successful in the market. History is littered with successful people following these tenets, including Warren Buffett and Charlie Munger, Benjamin Graham, T. Rowe Price, Shelby Davis, Philip Fisher (and his son Ken), and so on. While the allure of making a quick profit using technical analysis is undeniable, the list of people who have ridden it as a wealth building strategy is extremely short.

It's important to point out that technical and fundamental investing is not a black and white distinction. Most professional investors use the principles from each when making investment decisions, although they tend to lean more heavily towards one of the two distinctions. While this makes sense in theory, the fact is that balancing too many statistics when choosing stocks rarely provides more value. As James O'Shaughnessy points out in his investing strategy analysis book What Works On Wall Street, using two criteria when limiting your universe of stocks enhances returns greatly, but using more than that actually decreases returns. In effect, the classic K.I.S.S. ("keep it simple, stupid") advice is applicable to investing as well.

Disclosure: Steve owns no position in any stocks discussed in this article.

Comments

[investor88:]

The two methods trading vs investment: each has its own strengths and weaknesses. It depends on the occassion it is used and the psychological make up of the person. Some people combine the two methods in varying proportion. After all investment is an art as much as science, so there is no one method that suits all occasions.

In extreme times like the past one year, GOOD traders may have an edge because with cut loss capital is preserved. GOOD investors like Warren Buffet have also preserved capital.

2008 Oct 02 06:33 AM

[TSS:]

Joel,

Your article states that you should choose the path of investment over speculation as there is no concrete evidence to suggest that traders can out-earn investors.

"The last row of the table above illustrates the reason why you should choose the Investor path when building wealth in the stock market."

You state this as a fact, yet make no reference to the supporting studies that show a higher P&L using long term investing strategies Vs short(er) term trading strategies.

Additionally, you list a supporting cast of "investors" like Warren Buffet & Charlie Munger, yet by their own definition they aren't really pure play investors. Buffet is famous for half - joking that he has a holding period of forever for his buys. He wants them more for free cash flow then an inevitable sale - surely that is not buying and selling to some metric or as you state, "Sell when the stock price is rich relative to business metrics such as earnings, sales, book value, or cash flow."

The article goes on to say that the amount of traders who have made their fortunes by trend trading is far and few between, yet I can ramble off more names than you have listed as investors who have made untold fortunes: Loeb, Baruch, Livermore, Darvas, Victor Sperandeo, Weinstein, Richard Dennis, O'neil, Paulson & Stevie Cohen.

Another point of contention is that you describe the blending between investing and trading and then suggest it doesn't work citing only one work. Are there other works out there that you could cite for us that perhaps take on a different view? I am aware of hybrid systems with backtested data to support claims of stronger returns than if you were to simply use one style over the other.

My last critique of this article is that you use a sort of fuzzy logic in explaining that because there are some great long-term investors, that everyone who invests will have better returns than those who follow trends. That's analogous to stating that there are 2 really great medical companies out there, therefore every medical company must be great.

In truth, I believe it is more about the person. A super aggressive individual, will not make a great long term investor. Watching dead money sitting idle or taking you for a loss is just outside the realm of their understanding.

A patient individual with longer term horizons probably has learned to buy low and sell hi: they may not understand the concept of buying hi and selling higher and sitting on a stock with a PE of 200++. The concept of moving in and out of stocks quickly would probably be very unsettling.

Trading, to me, seems more about the man and their implementation of their system than the system alone.

In any event, good luck in this very tricky market.

TSS

2008 Oct 02 10:49 AM