The Difference Between Trading and Investing--And Why It Matters

 

Trading and investing are fundamentally different activities (pun intended).  Many trading psychology challenges occur when market participants fail to respect the differences between the two.

Trading is a bottom-up activity in which we assess supply and demand moment to moment to determine when buyers or sellers are dominant.  This enables us to place short-term trades with favorable reward relative to risk.  For example, readers know that I track the upticks and downticks among all the stocks in an index, so that I can see, minute to minute, if there are significant shifts in buying or selling activity.  I might see relative volume (volume as a fraction of the usual volume for that time of day) spike and upticks jump as well.  That tells me that new market participants have entered the market as aggressive buyers.  On the first hint of downticks that fail to push the market lower, I might go long to ride the upside momentum.

Investing, on the other hand, is a top-down process in which we assess company fundamentals and broad economic, monetary, and geopolitical conditions and infer from shifts among those whether valuations are low or high and whether they are likely to rise or fall.  The investor doesn't focus on what is happening moment to moment.  Rather, the investor is concerned with fundamental factors that impact the valuation of assets.  For example, the investor might read research suggesting that inflation will go higher through the year and might infer that this would put pressure on central banks to raise interest rates.  A scan across central banks and inflation trends across countries could lead to a view that one particular country's rates are unusually low relative to anticipated price rises.  Shorting the bond market of that country could be a worthwhile investment.

Market participants who are better wired to function as fast thinkers and pattern recognizers are generally best suited as traders.  The slower, deeper thinkers who possess stronger analytical skills are often ideally wired as investors.  Of course, there can be mixtures of the two modes, as in the case of hedge fund portfolio managers who trade actively.  Those active investors often have separate analytical and trading processes to draw upon each mode.

Problems occurs when market participants veer from their strengths and approach markets in ways that provide them with no edge.  The short-term trader will latch onto a big picture market view and will become inflexible as supply and demand conditions shift.  The macro investor will become anxious about market action and will find themselves staring at screens and managing positions based upon noise.  Usually, the short-term trader will latch onto superficial fundamental information when expanding their view, turning them into poor investors.  Similarly, the investor caught up in the minute to minute action of the markets typically lacks analytical tools for assessing short-term shifts in supply and demand and thus becomes a poor trader.  

This is why our greatest edge in markets lies in knowing ourselves and how we best process information.  What we genuinely see and understand in markets provides the conceptual underpinning of our success.  Just as the sprinter and distance runner cannot win in each other's Olympic events, so the trader and investor need to ensure that they are consistently playing the game that they can win.

Further Reading:

How Our Relationships Shape Our Trading

Spirituality and Trading

The Spirituality of Trading

Radical Renewal:  Tools for Leading a Meaningful Life

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Intrinsic and Transactional Relationships: Why They Are Important to Trading

 

In these posts, I attempt to provide perspectives in trading psychology that go beyond the usual platitudes and generalities.  Today's topic may seem unusual:  how our relationships shape our trading.

Consider the distinction between transactional relationships and intrinsic ones.  A transactional relationship is one in which each person agrees to do something for the other.  In that sense, it is like a business transaction.  For example, a couple could get married if one partner promised money to the other and the other promised social status.  Employer-employee relationships necessarily have a transactional basis:  one party provides a salary and benefits; the other performs expected work.

An intrinsic relationship is one in which there is a commitment to the other person, not for any specific things they are expected to do, but for who they are.  When a baby comes into a family, we expect nothing from the little one.  We love her out of an ongoing bond.  Similarly, in a good marriage, the parties are special to one another because of who they are.  

Transactional relationships are unusually fragile.  As soon as needs and interests change, or as soon as one person's ability to meet the needs of the other is diminished, the basis of the relationship is threatened.  If I've married a person for their looks, I may become less interested in them as they age.  If I lose my job, my partner may become disenchanted if money was central to their expectations.  At an intuitive level, we recognize that transactional relationships are selfish and ego-driven.  They are only as solid as certain conditions can be met.

Many relationships are mixtures of transactional and intrinsic modes.  Yes, there is a transactional aspect to working at a trading firm, but we are most likely to be loyal to an employer if they also display an intrinsic interest in our growth and well-being.  I can think of hedge funds that have portfolio managers who have stuck with them for years and years because of a personal commitment shown by management.  I can also think of funds that are known for firing traders as soon as they lose money.  Those funds generate little loyalty and have great trouble in retaining employees.

Even intimate relationships have their transactional aspects.  Yes, Margie expects certain things of me in terms of responsibilities at home and commitment to family and I have similar expectations of her.  But in a lasting, loving relationship, the bond goes beyond that.  I am confident that if Margie or I were to no longer fulfill our expectations due to illness or disability, the relationship would lose no element of love and commitment.  To use the terms of the Radical Renewal blog-book, intrinsic relationships come from the soul, not the ego.  Intrinsic relationships are necessarily unique, because they are grounded in what is special about the other person.  That is why, Fitzgerald notes, there can never be the same love twice.

So how are these ideas relevant to trading psychology?

If our interest in markets is purely transactional, based on what markets can give to us in terms of profits, then we will be unable to thrive during periods of inevitable drawdown.  You can always tell when a trader's interest in markets is predominantly transactional.  They talk about P/L, getting bigger in their trading, making more money, finding more opportunities, etc.  They rarely if ever talk about their fascination with markets, what they are learning from their trading and research, and how they are contributing to the development of other traders.  Once drawdowns occur, they experience emotional disruption, not because they lack discipline or because they're trading poorly, but because they cannot tolerate the frustration and emptiness of unfulfilled needs.

When our interest in markets and trading is intrinsic, we find value in our learning and development.  We are also motivated by the intellectual curiosity of finding opportunity in ever-changing circumstances.  Similarly, an intrinsic interest in trading is one that we're eager to share with others, fueling rewarding teamwork.  That fuels us--and our growth--when times are tough in markets.  I can not only survive during drawdown, but thrive, because it's not simply about how markets pay me out here and now.

Transactional relationships are about me; intrinsic relationships are about thee.  Often, we fail in trading because we make it about us.  Transactional relationships in markets are as fragile as they are in our personal lives.  No amount of time spent on working on mindset or setups can help us if we're trading to fill voids in our lives.

Further Reading:

Taking the Ego Out of Trading

How Our Bodies Become Our Souls

Radical Renewal:  The Spirituality of Trading

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Listening as a Core Trading Skill

 

Last week, we took a look at the challenge of trading markets that are ever-changing.  What that means in practice is that good trading begins with open-minded observation.  Are we seeing a continuation of previous market behavior, or are we seeing a change?  Markets trade thematically.  Sometimes the theme is risk-on and everything is trading higher.  Other times, we trade in a risk-off fashion, with pretty much everything declining.  Most of the time, the themes are expressed in relative terms, with certain asset classes stronger, others weaker; certain sectors of the market strong, others weaker.  Before we put our hard-earned money to work, we want to identify themes that are in play for the market.  That means that we don't blindly predict what we think will happen, but instead listen carefully to the market's communications and detect what *is* happening.

If you want to get on the floor with your partner and dance, you don't just start dancing.  You wait for the music to begin and adapt your dancing to what is being played.  

If you want to help a person in need, you don't just start giving advice.  You listen to what is going on in their life and adapt your response accordingly.  

As this post emphasizes, silence and a quiet, open mind are crucial skills of trading psychology.  Good trading requires emotional intelligence, not just cognitive complexity.  Every day, the market talks to us, and it is up to us to read the themes and make our decisions accordingly.  

The active trader who begins the day with preformed ideas--and who scouts for every possible "setup" that could confirm the ideas--is like the person you talk with at a party who is figuring out what they want to say before you've finished speaking.  Conviction makes convicts:  we become imprisoned by our expectations.  If markets are ever-changing, then we must be ever-open to change.

An important part of trading process, too often ignored by developing traders, is the maintenance of an open mind and the ability to quickly spot themes and shifts in themes.  Looking at chart patterns in a single asset misses the thematic nature of movement across markets.  First we find the themes; then we find the specific "setups" that provide us with a good risk/reward trade.  Once we place and manage the trade, we return to open-minded mode to detect further changes or trends.

Good trading does not replace negative self-talk with positive self-talk.  It replaces all self-talk with listening.

Further Reading:

Trading With Clarity

Relative Volume and Other Indicators I Find Helpful

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The Challenge of Adapting to Changing Markets

 

A stationary time series is a set of data derived from a single underlying process.  A simple example of a stationary time series would be the distribution of values from the rolling of fair dice.  Any given roll is not predictable, but the distribution of values over time would be stable.  

Suppose, however, that we used weighted dice and then changed the dice at random intervals.  Now each roll would not be predictable, but the distribution of values would also be random.  The distribution would no longer be stationary, as it's generated from multiple processes (dice).  

The stock market--and, indeed, financial markets in general--does not yield stationary time series.  This has been evident in recent markets.  If we compare the market from the past couple of months with the market from, say, the same months in 2019, we see very different patterns of trend/price change and volatility.  Correlations among stocks and sectors vary from time period to time period, as well.  

What this means is that markets are ever-changing.  This shouldn't be surprising.  Simply observing the differences in volume across various market periods tells us that the participants in the marketplace are not constant.  

The ever-changing nature of markets has a couple of important implications:

1)  Simply looking for patterns across various historical periods is apt to yield weak results.  Similarly, trading volatile bear markets with the same methods and "setups" as were used in range markets or low volatility bull markets is not likely to be useful.  A more intelligent process would be to identify a few key regime variables, study markets in those regimes, and identify trading patterns specific to particular market conditions.  A very simple analogy would be a football team that has to play different opponents and play in very different field and weather conditions.  The successful team will adapt to each set of circumstances with unique game strategies.  The successful team will not adopt the same strategy for all opponents and field conditions.

2)  Psychological disruptions often reflect poor trading processes.  It is commonplace to hear coaches and gurus insist that trading is a mental game and that the right mindset will yield consistent, profitable results.  If you understand point number one above, you'll recognize that the idea that poor trading comes from poor psychology is a limited perspective at best.  What commonly occurs is that we adopt one set of trading practices and strategies adapted to a particular environment, only to find that environment changing.  When the trading strategies that used to work no longer produce consistent profits, we become frustrated, fearful, etc.  The problem is not the emotions attached to trading:  those are the consequences of the more fundamental problem of not identifying and adapting to changed market conditions.

It is a commonplace observation that successful traders follow a disciplined "process".  If trading were like manufacturing widgets, that would be all that traders would need.  In an ever-changing environment, however, a successful trading process would need to include an assessment of the current environment and the opportunity set specific to that environment.  The successful trader is much more like the entrepreneur than the manufacturer of widgets.  Identifying and adapting to changing markets is central to success.

The changing nature of markets impacts active traders as well as investors.  The markets behave differently at different hours of the day, as we see different volume/participation and different event/catalysts across times of day and time zones.  Similarly, would we invest in the markets of the 1970s the way we invested during the 1990s?

And might it be the case that some market periods are simply not tradeable, if they change more rapidly than we can adapt our strategies?  

An important source of trading psychology woes is holding positions across non-stationary market periods.  Key to successful trading is knowing when to hold 'em and when to fold 'em.

Further Reading:

Common Mistakes Traders Make:  I

Common Mistakes Traders Make:  II

Common Mistakes Traders Make:  III

Pathways to the Heroic

Why I Am Proud to be a Trader

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