Daryl Guppy Articles

The difference between trading and investing

This is a popular, but incorrect question because it creates a confusing two way divide when there really should be a three way division. The correct division is shown in the diagram.

The investor is an asset income manager. He buys an asset such as a house, a government or corporate bond, or a share, because the asset delivers an income stream. He is particularly concerned about his return on capital as defined by the interest paid, the coupon rate, or the dividend rate. When he makes these calculations he starts from the price that he paid for the asset and looks at the income generated based on that price.

If the current price of the asset falls, but the income generated remains much the same then he sees no cause to sell. If the price of the asset rises dramatically he may be tempted to sell to collect a capital gain. This extra capital is then employed to buy another asset such as a rental property, more bonds, or other dividend paying shares that are available for a low cost.

When the investor makes a decision about how well, or poorly, his asset is performing he measures the rate of income against his original cost - not the current market price of the asset.

The trader has a different objective. He wants to buy a product from a supplier at one price and sell that product to the consumer at another price. His income comes from the difference between the two prices - the price he paid, and the price he receives. Trading is the activity which drives business. It does not matter if you are selling tinned food, televisions, computers, office furniture or shares. The underplaying principle is unchanged. We buy an item for one price and intend to sell it to a customer at a higher price.

The successful businessman trader buys items that he knows other people will want. He buys items that are in demand because he can resell those items at a higher price. If golf is the current fad there is not much appeal in filling the store with tennis racquets. We buy sets of golf clubs at wholesale and sell them at retail plus 10% wherever possible. We buy shares in a rising trend because there is a higher probability that we will be able to resell the shares at a higher price in a few day, or weeks or months time. Every now and then we get unexpected bonus on the sale. Others call it a dividend.

Here is where common usage conflicts with the correct understanding of these activities. When we talk about investing we include both asset income management and trading activities. We bundle the two together and this makes it very easy to fool ourselves when things go wrong.

It works like this:
• The 'investor' buys a dividend paying stock at a good price and holds it for the 'long term.' He is an asset income manager.
• The 'investor' buys a stock in a strong industry sector with a bright future. He pays the high price for it because he intends to sell it at some time in the future to collect the capital gain. He thinks he is investing, but in fact he is trading. He buys an item - the share - because he believes that others will want to buy it off him at a later date, perhaps in 'long term' for a higher price.
• The 'investor' buys a stock that was once strong but which has been in a slump for several years. He buys it because he believes the downtrend is about to end as demand for the company products improves, or management gets better, or for any one of a hundred reasons. He buys this bargain because he believes that others will want to buy it off him at a later date, perhaps in 'long term' for a higher price so he is prepared to wait. He has no income from the asset while he waits. His profit depends entirely in capital gain. He is trading, not investing.
• The 'investor' buys a strongly performing stock that does not pay a dividend. It continues to rise in price for a few months, and then it rolls over into a downtrend. The downtrend continues for several years and the 'investor' still holds onto the stock. In fact, he might even buy some more because it is now cheaper then when he first bought it. His intention is to sell the stock at some time in the future for a higher price than he paid for it. His profits depends on the difference between his buy price and his sell price. He might believe he is an 'investor' because he is dealing with a well known, high profile, well respected listed company, but his purpose is not different from the 'investor' who buys a small bio tech company hoping to sell it for a higher price at some time in the future. Both are trading, not investing.

The activities of an asset income manager are very different from that of an 'investor'. However, common usage of the term 'investor' combines and confuses asset income management with the business of buying and selling a product - listed market equities or shares. When we talk of investors in this newsletter we are NOT referring to asset income managers. We are talking about 'investors' who aim to make a capital gain from their activity.

RELATED TOPICS - TRADING PERSONALITY Market myth proposes an excellent three step trader's training course. First the student is required to put $100 on a busy city footpath and wait until a passer-by picks it up. When the student is able to watch this happen without wincing and without tears he proceeds to the next step in the training course. The second stage is a repeat of the first, only using $1,000. The stage is successfully completed when complete nonchalance is achieved. The third step involves $10,000. The student must repeat this successfully, throwing money away without tears or fears, for several consecutive days. Successful completion of the course entitles students to start trading. I jest, the course is mythical, but the intent of the exercise is quite serious. All traders lose money, and they often lose it on a regular basis. The key difference is successful traders lose only small amounts of capital. The failed trader is a gambler who loses large amounts of money because he cannot admit he has made a bad choice of trade. Our personality has an important role to play in trading success.