“Let us be thankful for the fools. But for them the rest of us could not succeed.”
- Mark Twain
The difference between investors and traders is almost religious in fervor. Ironically, both have the same goal: to make money. But each approaches that task in a different way. At first glance, investors hold stocks for the long term, while traders buy and sell stocks on a short-term basis. But the real distinction is more philosophical. Investors view stocks for what they are: pieces of paper that grant ownership in a company. Traders view stocks as gambling chips: things to be bought low and sold high regardless of what they actually represent.
This philosophical difference leads to significantly different behavior. Trading is a zero-sum game, meaning a game in which for every winner, there must be a loser; with investing, there may be many winners at once. Keep in mind that when we talk about traders, we are talking specifically about day traders — that is, people who zip in and out of stocks and close out all their positions at the end of the day.
Let’s explore this concept with George, who is an avowed trader: he buys and sells stocks rapid-fire, hoping to outsmart his opponents and make lots of money. You may be asking who his opponents are. His opponents are actually the other traders he trades against. If George goes out and buys a share of Lucinda Lemonade for $2, he’s not buying it in a vacuum. There is someone selling it to him for that same $2. Presumably, George believes Lucinda Lemonade will rise in price — that is, his $2 share will soon sell for $3 or $4, and he can reap a handsome profit. Meanwhile, the trader who is selling the $2 share of Lucinda Lemonade believes the share will decline in price. Otherwise, why would she be selling? If you think about it for a moment, you’ll see that they can’t both be right. One must win, and one must lose. The share will either rise or decline in price, and only one will be happy with that outcome. If the share quickly doubles in price to $4, George can sell it and pocket a 100% pre-tax profit — a nice day’s work for a trader. Of course, this means that the trader who sold him the share is regretting her premature sale that robbed her of that same 100%.
In contrast, along comes our investor, Liam. Liam buys stocks and holds them for the long haul, understanding that a share represents a real stake in a real company, a company whose overall success will determine the future gains (or losses). If Liam buys a share in Lucinda Lemonade, he doesn’t do it because he feels it will double overnight, but because he thinks the business is a good one that will grow over time. He bases this decision on factors like the company’s business plan, cash flows, balance sheet, and management. If George were also an investor, he too could buy a share in Lucinda Lemonade and hold it for a long time. If the firm is successful, both their shares will increase in value, and both will reap the rewards. They can both buy shares of Lucinda Lemonade Inc. and bide their time. If the company doubles its profits every 10 years, the stock price will likely double on a similar schedule. Both George and Liam can see their $2 share appreciate rapidly. Neither one has made money at the expense of the other. Rather, they have both made money due to their roles as investors in an expanding company. The pie has grown for all investors in the company — the opposite of a zero-sum game.
You may ask why anyone would be a trader instead of an investor. One reason is psychological. Trading is akin to gambling, an activity of action and excitement where quick (often random) decisions affect the outcome. Anyone who’s been to Vegas knows that it’s more fun (though often less profitable) to ante up your chips than to sit in the background and watch. Trading is more like stepping up to the roulette wheel: you get to place your bets, go for a quick win, and experience the immediate emotions of elation or depression. Investing is boring by comparison.
The other, more complex reason is that trading can be profitable, if you’re good at it. Remember, in a zero-sum game, there’s one loser for every winner. But it follows that there is also one winner for every loser. And often the winner really does take all. The advantage trading has over investing is that such a win can happen very quickly, in a day, or even a minute. The investor has to wait out the future profit growth of a company; the trader exploits a distortion they think will correct itself quickly. For example, the trader may feel that an oil company’s share will double in price overnight, due to a terrorist attack in the Middle East. In all likelihood, such a tragedy will not affect the company’s long-term business prospects. But in the short term, it could raise the price of oil, creating a pop in the stock prices of oil companies. Notice how a trader does not have to wait for the mundane, long-term appreciation in the stock price that will stem from business expansion. Rather, the trader can exploit a sudden opportunity and run with it, reaping huge profits in a flash. But remember the flipside: for every winner, there’s a loser. Someone will be left holding the bag.
An idea that follows from the distinction between traders and investors is one that explains their behavior: traders will sell on a dent in price, while an investor will only sell on a dent in the underlying value. The investor will hold a stock as it declines, as long as the underlying value hasn’t. If he were to sell, that would be like selling a million dollar home for half as much, just because that’s the only offer at the time. If you believe the true value is higher, you’ll wait until it climbs back in price.
An investor might sell because he expects his stock to be threatened by new competition from another company (a dent in underlying value). He doesn’t know when the stock price will reflect this development. Rather, he makes decisions based on underlying value, not price. Notice that investing does not mean always holding a stock forever. On the contrary, it means selling a stock very swiftly if the underlying fundamentals deteriorate, or if the price outstrips those underlying fundamentals.
The bottom line is that investing is better for most people because they can share an ever-expanding pie. By definition, only half of all traders will be successful (in practice far fewer, due to the house’s “take” in the form of commissions, transaction fees and bid-ask spreads), whereas the majority of investors can be successful if they invest in a well-diversified portfolio of quality companies for the long term. In fact, there are few instances of investors losing money over 20-year periods, but the landscape is littered with dethroned traders who’ve literally gone bust. This is why investors often have long careers, while traders come and go.
A discussion of trading leads us to the subject of options, which we will just briefly mention here. We are not talking about the stock options that many people receive in exchange for their work at a company. Those options are often an excellent and lucrative type of compensation.
Rather, here we are talking about options that are purchased on the open market. The most important thing to remember about options is that they can be completely ignored by long-term investors. An option is merely a right to purchase something in the future at a preordained price. If you buy an option to purchase a stock, you’re betting that the stock price will be at some particular price at some particular time. As such, options encourage speculation on the short-term movements of stock prices. Options are often called “time-wasting” assets, meaning that they can lose their value over time and then expire valueless. Since options are a form of trading, the average investor is best served by ignoring their existence. Options require you to know not just what will happen but also when it will happen. That’s a tall order. Knowing the “what” is hard enough without bothering with the “when.” Some people say that options can limit your downside, since you only risk the small amount you spend to buy the option. That’s true — in the same way that a $1 lottery ticket can limit your downside, precisely because it has little prayer of being a winner.
A final way to understand the difference between trading and investing is to imagine the threat of a tsunami threatening the shores of Lemonville. In order to predict this possible calamity, some people would inevitably watch the ocean surface, hoping to catch a glimpse of a distant swell. But scientists who are savvy to the actual mechanics of tsunamis would watch the ocean floor, where fault lines in the earth would shift, giving the first hint of the great wave. Traders watch the surface activity — price fluctuations — hoping to catch a glimpse of impending doom. Unfortunately, impending doom can’t be spied there: to spot the tsunami early, the investor instead looks beneath the ocean surface for underlying changes in the company itself.
Trading does promise more excitement. It’s hard to compete with that. Trading allows you bask in a garish casino glow; investing puts you on the phone with accountants under a green banker’s light. You can see why most people prefer trading to investing and why casinos are more popular than courses in stock valuation.
“Those who don’t count on luck have less bad luck.”
- Yiddish Proverb
Luck may be a lady, but she has no place in your investment plan. Of course, fate is inevitable and markets have a mind of their own, but the important thing is to replace luck with research and discipline.
A trading strategy can sometimes derail an investment plan because trading fosters a gambling mentality. If you want to gamble, go to Las Vegas: at least you’ll get the free drinks and a day by the pool. But if you want to save for your retirement, then do your research and invest for the long haul. Gambling is the number one reason people fail in their investment plan. Some on Wall Street don’t want you to hear this — especially companies that make money off trading. But it’s the truth.
This isn’t to say it’s impossible to make a good living as a stock market gambler. Some can, but the odds are stacked against them. While it’s never a great idea to play a game with the odds already against you, a gambling mentality can be hard to shake. Take the following example to understand this dilemma, which is just a version of a classic probability question: Assume that George jets off to Vegas to try his luck. After all, casino gambling is illegal in Lemonville, and George has taken some hard knocks from the LTSE. When he arrives, he goes right to the first casino, where he sits at the roulette wheel and orders a lemon daiquiri. George watches the game for a while, refining his “system.” He watches the roulette wheel land on red three times in a row, and he’s curious to see if the streak will continue. Sure enough, on the next roll, the wheel lands once again on red. George starts to think that if the wheel has landed red four times in row, it can’t possibly happen again. After all, he reasons, it has to land on black eventually. He scoops up all his chips and bets it all on black. When the wheel stops spinning, it hits red once again. He loses everything. He hops the first plane back to Lemonville.
Many a Las Vegas junket has run according to that very script. If you understand George’s error and its psychological temptations, you understand why investors have long careers, while gamblers come and go. It’s not that George is a fool. In his rational mind, he knows that every time the roulette wheel spins, it has the same odds of landing on black. But a bizarre psychological noose wrings an otherwise rational gambler’s neck. The gambler starts to believe that black is a surefire bet on the next roll. Unfortunately, many gamblers are convincing to themselves — so convincing that they put their money where their misguided mouth is, with unsurprising results.
Trouble occurs when this shaky casino logic gets applied to stock market trading. George, for example, might have been watching the closing price of Lucinda Lemonade Inc. for several straight days in the Daily Lemon, the local Lemonville newspaper. He noticed that the stock has risen in price for several straight days. He therefore reckons the price will rise again today. Again, based on the faulty law of averages as defined by George, he saw a sure bet. He bought $100 worth of Lucinda Lemonade stock and watched the price collapse instead.
You might doubt anyone actually makes decisions this way. On the contrary, many do. Traders who are gamblers see little difference between the tables at Vegas and the stock exchange. When stocks become like chips, they become subject to a gambler’s off-kilter logic, which is why the average investor is much better served by a value-oriented, long-term approach to the stock market that looks at stocks for what they really are: stakes in a business, not gambling chips.
“No one knows who’s swimming naked ‘til the tide goes out.”
- Warren Buffett
An inevitable fact of investing: from time to time, the tide goes out. In other words, bad things happen. You just don’t want to be “naked” when that time comes. It’s easy to stay dressed and prepared if you do your research and buy quality investments.
If you live by the Lemonade Laws in this book, you’ll increase your chance of success and you’ll sleep well at night. Just as the best in life comes down to simple principles, so does investment. It’s easy to be intimidated by the daily news and chatter, but common sense is the best investment tool.
If something sounds too good to be true, it usually is. If something is called risk-free, it probably isn’t. If your tippling neighbor tips you off to a “sure thing,” it always pays to do your own research. And if you don’t want to look silly when the tide goes out, wear at least a bathing suit.
We all know these rules at heart. Our common sense was acquired at a young age. But when things like money enter the picture, we sometimes forget. There’s no reason this has to be so. A simple, disciplined approach to investment works wonders to restore our better financial selves.
In Lemonville, the stakes are low: a nickel here, a lemon there. In real life, a good investment plan can mean a comfortable home, college educations for the kids, a carefree retirement. A bad one can lead straight to the poorhouse. There’s no reason why everyone can’t follow a solid plan, one that will stand the test of time and might even make you wealthy. After all, the corner lemonade stand taught us more than we ever knew.