Friday, August 7, 2009

Investor or Trader: What's the Bottom Line?

"Buy and hold" say the long-term investors. "Sell losers quickly to cut losses" say the short-term traders. "We are in it for the long-term" say the investors. "Hold only rising stocks, and let profits grow" say the traders. Though most people who call themselves "investors" are not really disciplined, those who are disciplined have much in common with traders.

Most investors are happy if they get a return of 7% to 10% a year. Most traders feel like a failure if they have not achieved at least a 30% return. Investors feel elated if they get 15%. Traders feel the same if they get 60%. On rare occasions an investor will get a return of 30% to 35%. Some traders get occasional returns in excess of 100%. In general, seasoned traders aim for a return that is three to four times as high as that of an experienced investor.

Many "investors" buy shares in a few mutual funds. Mutual funds tend to hold onto stocks while they rise and fall. Other "investors" buy a basket of stocks and hold them while they rise and fall. Both of these groups will, on average, obtain performance that is not too different from that of the market as a whole. On the other hand, "traders" often beat the market's performance by a wide margin because they are selective, pay attention to timing, and do not ride their stocks up and down. They are disciplined in both their buying and selling. Stocks often evidence characteristic patterns of behavior when they are setting up for a meaningful rise. Traders learn to recognize those "setup" patterns. When a stock begins to fall they sell and buy another that has completed an attractive "setup" and that has just initiated a high-volume momentum surge.

Most traders will buy a stock then follow it up with a stop-loss order placed at a calculated distance below its current price. This "stop" is raised each day as the stock rises. These traders do not have to make a separate decision about when to sell because the stock sells itself when it drops to the stop price. For them, stop-placement defines one-half of their buy/sell activity. Our traders use both primary and a backup selling systems. The primary system is usually a well-defined and sensitive discipline that can sometimes generate a sell signal before a well-placed stop is triggered. They also use a stop loss as a backup safety net in case their discipline does not sell quickly enough. You can benefit from their experience by doing the same thing. Stop placement should define at least one-half of your sell discipline.

Let's look at the difference in attitude between most investors and most traders. Most investors will hear of a stock that has been in the news lately because of a new product, technology, discovery, or potential cure. They will say to themselves something like "XYZ Co. is a great company. Someday they will cure cancer. I should buy some of that." Then they buy it. They believe in the company and its long-term growth prospects. During the following year, the stock may fall 5%, rise 17%, fall 15%, rise 20%, fall 10%, rise 17%, fall 7%, and finish the year up 17% from the original purchase price. The investor will be pleased with his decision and with the profit he has made. If a trader hears about the same stock, he will not do anything without first looking at a chart. He will observe that the stock is declining, and will not do anything until the stock nears support or until the stock completes a setup configuration that the trader likes. Then, as momentum begins to build, he will buy and follow the stock up with a stop loss. His approach will give him a high probability of capturing a good part of each rise and of avoiding most of each decline. His total return will be much higher, and his risk will be much lower. Why do we say his risk is lower?

We say his risk is lower because there is no guarantee that any stock will recover. If it doesn't, then buying and holding is riskier than selling immediately when the stock misbehaves. For example, many investors held on to LA Gear when it began to decline, refusing to take a loss when doing so would have allowed them to recover most of their money. They assumed they could get all their money back when the stock recovered. They told themselves that to "buy-and-hold" was the smart way to invest. They might have even patted themselves on the back and proclaimed that they were long-term investors, not "twitchy traders." LA Gear's stock eventually became worthless, and the entire amount invested simply evaporated (not just the small amount of loss that investors were hoping to regain). Genentech fell over 77% from its high (even though TPA was supposed to generate annual sales in the billions and Genentech had the patent rights). Yahoo dropped from $250.06 to $8.02 (over 96%). IBM fell over 76% from its high in 1999. CMGI sold for $163.50 before it plunged to .28. Broadcom was $274.75 before it dropped to $9.52. JDS Uniphase sold for $153.42 before it declined to $1.58. Unisys sold for $48.37 in 1987 before it dropped to $1.75. Each of these stocks had a good story. Some of these stocks no longer exist. None of them are even near their previous highs, and there are many others like them. Any stock can have a similar drop. To us, riding a stock down when it is headed for oblivion is assuming a great deal of risk. These investors cling to the mantra that buying and holding is the correct way to invest because they do not have a discipline for selling, just as they have no real discipline for buying.

High performance longer-term investors (names like Zweig, Dines, Sullivan, Weinstein, Granville, Murphy, and others come to mind) are similar to traders in many respects. In a good year, these people might earn 20% or more while the market rises 10%. They all advocate the use of stop-loss orders to protect assets. The main difference between them and traders is that they have a longer time-horizon, and their stop loss orders allow a greater range of price fluctuation. Like the sophisticated traders, the most sophisticated longer-term investors use stops that are no more distant from the price action of a stock than is appropriate for its volatility and the investor's investment time-horizon. The fact that they have a longer holding period does not mean they can be sloppy with their stop placement. Their targeted gains are much smaller relative to the time invested than those of top traders. They cannot afford to take large losses. Pattern-relevant stops and Volatility-adjusted stops are just as important to top investors as they are to top traders.

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