Sunday, May 29, 2022

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