# Investing versus trading.



## darag (18 Jul 2009)

I was reminded of this thread recently.  It is a very confusing thread so I thought I'd try to describe the fundamental differences between trading and investing.

First of all, there seems to be an underlying tone of skepticism that traders can make money at all but I think this reflects a confusion about what it is that traders do.

Trading not only has little to do with investing - they are almost opposites.

For example trading requires constant effort; I'm fairly sure it cannot be done on a part time basis unless you get very lucky.  In contrast, investing is about getting your money to grow with the minimum amount of work and effort.

Trading is not about market timing, in the way that "investment gurus" talk about it, and it certainly isn't about any of the sort of "technical analysis" which limerickboy1 suggests in the thread above; no trader is going to sit around for weeks waiting for a two month moving average to cross some threshold.  Most traders view this sort of technical analysis (looking for "head-and-shoulders", etc.) as the complete rubbish that it is.

Traders strive to have as little exposure to the markets as possible; ideally a trader will have no position at the end of a session.  A trader will have little or no long term exposure to the markets at all while investing is about building up exposure. Of course for a trader to make money in the markets they need to be exposed but generally a trader wants all their money in cash at the end of a session.

Trading involves exposing yourself to zero or very low risk.  Successful traders are risk adverse. In contrast, investing involves a trade off between risk and reward (the "efficient frontier") - without risk you get little or no reward.  This is why investing only works in the long term - you need to take on risk to get a return but you need a long period to lessen the damaging effects of volatility.  Trading is the opposite - the quicker/shorter the market exposure, the better generally.

Trading is tricky and requires study and often computing power; they are competing with their wits against others.  Smarter traders will generally do better.  On the other hand successful (stock market) investing is the opposite - you are much better off following the most simple-minded strategies - buy the indexes as cheaply (in terms of expenses) as you can with a proportion of your wealth and keep the rest in cash (earning as much deposit interest as you can get). As soon as you try to get fancy, you'll damage your chances of making a return (e.g. by actively managing your equity investments or paying some-one to do it for you or by buying hokey bundled products like tracker bonds and the like).

These days trading has little to do with the bustling mayhem of the open-outcry system or barking orders to brokers on the phone you see in the movies. Most traders spend their time quietly looking at computer screens.

Traders will generally be secretive about what exactly it is they do.  If they've discovered an opportunity to make money on the markets, why would they share it?  Usually these arbitrage opportunities are fleeting - if the trader is lucky it may last months or years but it would certainly be stupid to tell others about it.

It is not at all fair to quote rates of return from trading as if they were in anyway comparable to the returns available from investing which is one issue I'd have with lamur's posts.  When a trader says they make a 80% return each year, they are talking about return on capital, not a compounding rate.  You cannot just make 100% one year, "reinvest it" and make double the next year, etc.  A trader's return is more like the ratio between a pro poker player's bankroll and their winnings in a year.  A poker pro would never claim to have made 1000% return in a year because they made 10 times their bankroll (not at all uncommon for top players) - it's not like they can compound their winnings and make 10 times more again next year and again the year after that or anything even like it and traders are being disingenuous bandying around figures like as it gives the wrong impression entirely. 

When they talk of an "edge" in trading, it has nothing to do with qwertyuiop's  suggested set of rules in that thread.  It goes without saying that traders will avoid the risk of ruin but there's a trivial strategy to achieve the same - don't buy or sell at all.  However traders hope to make money on most of their trades so the more trades they can do the better generally.

A trader's edge is generally based on arbitrage opportunity or some timing discrepancy in the markets of some type.  For example some traders will spend a huge effort  studying some small niche corner of the markets to find some instruments that offer the opportunity to arbitrage.  The markets may (or may not) be efficient at the macro level but at the micro level there are plenty of inefficiencies - admittedly many small and difficult to exploit.  They will then design a strategy - often using futures and options - to exploit this correlation. The correlation may not last - hence the secrecy around this activity - or the trader may get lucky and be able to milk it for months or even years.

The real point of this post is that the fact that money can be made trading DOES NOT mean that any of the skills or techniques are transferrable to  improving your pension fund returns. Trading and investing may seem superficially similar (it may seem like the only difference is the time scale) but they are completely and fundamentally different activities as I hope I've pointed out above.

Successful trading is beyond the layman and to even to attempt it is more likely to result in being wiped out.  You are going head to head with specialist trading houses all over the world as well as smart and experienced lone traders; some of your competitors will have 10s or 100s of millions worth of computing power and networks, others will have years of experience in some small dark niche of the markets.  Successful investment on the other hand is possible by following relatively simple rules (but I have to say I think the investment guide associated with askaboutmoney is flawed in many ways).  It is a grave mistake to confuse the two and try to combine trading and investing.

However it serves no interest to deny that it's possible to make money trading; this is simply not the case.


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## Brendan Burgess (18 Jul 2009)

I think that the key point here is that trading is a negative sum game in the same way that gambling is. 

For every winner, there is a loser. But the winner does not win as much as the loser loses, because the brokers take commissions along the way. 

Maybe there are consistent winners, but they are few and far between. And for every winner, there are thousands of losers. 

People do not report  their wins and losses honestly, so you hear about the wins and not the losses. I have tried to explain this to a few traders over the years and they all believed that they were in some way special and could beat the market. They all went bust eventually. 

Unless you are a maths genius, you have no chance of beating the market on a consistent basis.

Brendan


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## darag (18 Jul 2009)

Hi Brendan, I don't think Trading is a zero or negative sum game at all.

Perhaps I should have capitalised the word "Trading" as it has a specific and precise meaning within the financial industry.  I'm trying to describe Trading (as a concept in the finance industry) not the generic idea of trading (i.e any type of buying and selling).  I feel there is a lot of confusion out there about it and your response confirms it.

It is a specific type of market activity conducted by all sorts: from huge teams in investment banks, to smaller specialist "trading houses" to tiny one or two man operations.  When you read of "traders" in the financial press, this is what they are talking about.  The characteristics I described in my previous post apply to "Trading" not the general activity of buying and selling shares, futures or options.

Selling your BOI shares for CRH because you feel you've worked out something or other does not qualify as "trading" within the financial world.  Warren Buffet is certainly not a "trader".  Nor are any fund or portfolio managers even though they do a lot of buying and selling.  Nor is the likes of Dermot Desmond even though he buys and sells lots and seems to be able to time markets.

I've listed some of the common characteristics of Trading in my previous post but to repeat: within the financial world, Traders generally strive to have ZERO exposure to the markets - a trading desk (as teams of traders are called) generally wants all its money in cash when they leave their desks at the end of the day.  All the "rogue trader" stories involve Traders who built up positions in markets - in all cases this was considered fraudulent and generally they achieved this by hiding their position in separate accounts and what not so that their managers couldn't see what was going on; the reason they had to fiddle their accounts was because Traders rarely or ever have the authority to hold long term (more than a couple of days) positions in the markets.

Back to the zero sum game idea.  Traders do not make all their money from other traders, even though they can and do make money from each other.  It's more that Traders are competing with each other to find and exploit all the little inefficiencies in the markets.  Market making is a classic Trader activity; the nearest familiar analogy outside of the industry would be the on-course bookies you see at horse racing meetings; yes bookies can have ups and downs and the interaction between the bookies themselves is a zero sum game but overall, the bookies are operating in a positive expected value environment.  Clever bookies (or increasingly you see computers and laptops) can hedge their positions better and thus compete more aggressively for punters and make more money.  At the end of the racing, everyone is in cash.

My point is that the skills involved to be a Trader have practically NO applicability to managing a portfolio of shares as their work never involves having a large exposure to markets.  Within the finance industry, a person who has proven they can trade profitably would never be considered to be qualified to advise on portfolios of shares.  These are entirely different fields within finance.  A successful on-course bookie would NOT be hired to be a professor in a statistics department on the basis of the idea that they must be great at calculating probabilities.

Outside of the industry there is great confusion; "Traders buy and sell shares  and stuff and can make money at it so surely if I could Trade well, I'd be able to manage my pension fund better?" - the answer is absolutely not.  This is no more true than expecting an excellent golfer to be able to transfer their skills to tennis; yes both sports involve hitting balls with some sort of implement but that's about it.  The danger when it comes to personal finance is that outside of the finance industry few laypeople grasp the fundamental and vast difference between what Traders do and what is required to invest successfully in the markets.  I am trying to explain why Trading is not relevant to managing your personal wealth.


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## Brendan Burgess (18 Jul 2009)

You are describing features of trading e.g. trying to avoid risk, but not defining trading. 

I would have thought that trading, as distinct from investing, means to buy and sell rapidly. Probably within the day, but not necessarily.

So if I think oil will rise and then fall again, I buy it on margin and sell out again to take my profit probably before the end of the day. This is a negative sum game. 

The only place where trading can be profitable is where there is an underlying real transaction where the person on the other side does not mind making a loss. So, Ryanair wants to buy all its oil at a fixed price for the coming year. For this insurance, it is prepared to pay a fee. But the volume of real underlying transactions is dwarfed by the volume of trades between dealers where there is no underlying transaction. So dealing or trading is a huge net negative sum game.


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## darag (18 Jul 2009)

Nope.  I am describing what the activity of "trading" refers to within the financial industry.  Buying and selling rapidly is not the defining feature of what trading desks do.  Many other activities in the financial industry involve buying and selling rapidly (did you mean frequently?) but are not considered "trading".

You are confusing other activities within the finance industry with what is referred to as trading.  None of hedging, dealing, managing funds, selling instruments (while buying or selling others as a hedge), etc. is considered to be "trading" which has a specific technical meaning within the industry and describes a very limited set of activities.

I believe that markets are largely efficient and that you cannot improve the performance of your investments by buying and selling more frequently - in fact the less buying and selling you do the better.

I also do NOT believe that trading (in the technical sense the word has within the finance industry) is a zero sum game.  These are not contradictory positions as I've tried to explain what "trading" actually involves.

I'll have to think again about how to communicate this.  I think it is important but difficult to explain.  I certainly did not appreciate this myself until recently.

The on course bookies is the nearest familiar example I can think of which comes close to describing what the activity of "trading" involves in this technical sense.  Before each race, the bookies place bets with each other and accept bets from each other - a zero sum game for sure - but there are enough other people involved in the "market" (for odds in this case) that bookies still earn a living.


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## Brendan Burgess (18 Jul 2009)

I think that you will have to edit the original post to define, as distinct from describe, trading. 

Over the years people have told me that they are "trading". They have a seat on an exchange somewhere or else they do it from home online and they trade currencies or shares or commodities. 

In banks, there are trading desks, where people are taking positions on currencies or interest rates. Maybe these are not what you mean by traders? 

I have looked up the dictionary definitions and they are not particularly useful. 

However, by "trading", I mean "day trading" which is probably not what you are talking about? 



*Day trading* refers to the practice of buying and selling  within the same trading day such that all positions will usually (not necessarily always) be closed before the market close of the trading day. This is the opposite of .  that participate in day trading are called .


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## darag (19 Jul 2009)

Brendan, I have no doubt that many people like to consider themselves they are "traders".  In Ireland particularly, I know many who in the last 2 or 3 years have gotten into speculative share purchases (maybe not for huge amounts).  They are not traders in the sense used in the financial industry.

Yes there is a sub-category of professional traders called "day traders" but this classification scheme makes it sound like this is a niche aspect of trading.  In fact most professional traders only hold their positions for a day or less.  At the very most, traders may keep a position for a week or so but usually this is only because they are forced to because of market conditions.  I would guess that 90% or more of professional traders exposure to the market in a particular instrument lasts less than an hour.  The vast majority of trading desks strive for an all cash position at the end of the working day.

The point is that they strive for NO exposure to the markets; their default position is all cash - they get in and out of markets but only because that is how they earn money.

In contrast with investing you want full exposure to the markets in order to exploit the general ability of the capitalist system to generate growing profits.

Trying to both trade and invest at the same time is a terrible and fundamental mistake and is completely self defeating given the fundamental opposite goals (traders want to minimise their exposure to overall market movements while investors want to maximise their exposure).

My original post actually describes what traders do in the industry.  Not many people understand what they do; I certainly didn't until I started to see the mechanics of trading first hand as part of my work.


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## dubrov (21 Jul 2009)

I think the term "trader" is a loosely used term in the financial industry. It generally refers to person whose job involves buying and selling bonds/shares/commodities etc.. Most "traders" days are actually quite routine. 

I think darag is referring to a subset of this known as "proprietary trading". These guys take short-term positions of normally less than 3 months with the aim of financial gain. They can range from your Joe Bloggs trading nline with €1,000 to large trading desks in investment banks with millions of euros in capital. The sophistication of the trading strategies varies accordingly. 

As an example, a simple common trading strategy is know as the long-short position. A trader might analyse companies which are in similar sectors and have similar business risks, say BOI and AIB. He might using various information consider AIB cheap when compared to BOI. However, he may not want to buy AIB outright as even if he is right, it may turn out that both are way overpriced. There are many other risks such as market risk, regulatory risk etc. He can hedge most of these risks out by going long AIB and short BOI. The trader doesn't care about the market going up or down. He just needs AIB to outperform BOI.

Also, I wouldn't regard technical anaysis as total hoodoo. Although most valuation models assume the Markov property, investment banks do invest large amounts of money hiring quantative analysts to develop software to try and identify patterns in the market.The software will automatically execute strategies when the patterns occur. Some stragies win, some lose but I'm guessing in the long run a profit must be realised as otherwise banks would be pretty quick to pull the plug on it.


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## EAP (23 Jul 2009)

I am beginning to wonder what point is being made here. Darag/ Brendan you make a lot of interesting points above. I won’t debate all of them. Is the main point that Trading and Investment are two very different disciplines? 

If so, I couldn’t agree more. But the fact is that Trading (in whatever sense you take it to mean) is not a zero sum game, it is a NEGATIVE sum game. Negative because of the point Brendan makes about brokers etc deducting commissions along the way. If you sit down at a poker table with ten people, some will win and some lose, but the house is the only real winner due to its rake. 

I don’t believe markets are efficient (Darag you believe they are largely efficient - how large is large?). The follow-on is that there are inefficiencies to exploit and make money on. Yes, there are, but not for traders. Markets are not efficient in the EMH sense of prices reflecting all knowable information and fundamental research being redundant. But markets are efficient enough that easy trading profits will be arbitraged away. The ‘skillful’ trader can persist for many years picking up pennies in front of a steam roller, but eventually gets flattened. The problem with many investment banks and the ridiculous bonus structures is that they pay these traders for picking up the pennies and it’s the company that gets flattened in the end not the trader. If a trader makes money, possibly consistently, he/she should consider him/herself extremely lucky and not skillful. 

People exploiting market inefficiencies are not exclusively ‘Traders’. The exploitation of market inefficiencies is the strategy by which long term investors ultimately make money. Buffett is exploiting market inefficiencies, admittedly with a time horizon which is far longer than most. So it seems the distinction between trading and investing is one which boils down to timeframe.


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## Askar (23 Jul 2009)

If markets were efficient we would have no asset bubbles. There is a good lead article in current edition of the economist on this. The deficiencies of this doctrine have been shown up by the financial crises and house price collapse. 

Recently read a brief article in TMF about the difference between both. I could not find a link; but they identified Buffett as an investor - no clear exit strategies and Soros as a classic trader - waiting for market to react and then exit - as in his leveraged bet against sterling in the early nineties.


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## Marc (23 Jul 2009)

Askar said:


> If markets were efficient we would have no asset bubbles.



Two answers to this view:

*Gene Fama Professor of Finance University of Chicago and father of the Efficient Market Hypothesis*: "Every market determined price is an equilibrium price that should take account of all information available at the time the price is set. (This is the definition of market efficiency.) But things inevitably change, and equilibrium prices change along with them. All we can say about the recent market turmoil is that the volatility of information and its implications for forecasts of profitability must be quite high." 

*Ken French Professor of Finance Dartmouth College*: "Market efficiency does not imply prices cannot change. It does not even say they cannot change by a lot. The key question is whether we should have known the Dow would drop from 14,000 to 7500. Some who made fortunes by anticipating the drop seem to have convinced many observers that the outcome was obvious, but that is just history being written by the victor. Unlike the technology boom of 1999-2000, I don't recall lots of conversations in which people struggled to understand why the Dow was at 14,000. "


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## EAP (24 Jul 2009)

The debate seems to be moving away from the original point about trading and investing, to one of market efficiency. This point could form the basis for a separate category on AAM, never mind separate thread.

EMH has been progressively revised, both by its original author and others, to try and account for the many paradoxes to the theory we have witnessed in the last decade. Eugene Fama is no doubt a brilliant mind, but I think the debate on market efficiency has moved on. There is fairly widespread acceptance that EMH does not explain the complex world we live in. There are elements of EMH which are true, but as a theory to explain stock market dynamics, it should be considered as merely enlightening. 

Back to the original point of trading and investing -I do agree that Soros is the epitome of the classic 'trader' and he clearly has made money, consistently. It is identifying these success stories in advance is the difficult (impossible even) task.


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## Chris (24 Jul 2009)

Marc said:


> Two answers to this view:
> 
> *Gene Fama Professor of Finance University of Chicago and father of the Efficient Market Hypothesis*: "Every market determined price is an equilibrium price that should take account of all information available at the time the price is set. (This is the definition of market efficiency.) But things inevitably change, and equilibrium prices change along with them. All we can say about the recent market turmoil is that the volatility of information and its implications for forecasts of profitability must be quite high."



All he is basically arguing here is that supply and demand dictate the price. Efficient market theorists also make the fundamental mistake in the assumption that on balance market participants make correct judgements on all available information. It does not take into account, that very often the majority of participants have serious misjudgments and misconceptions based on available information.




Marc said:


> *Ken French Professor of Finance Dartmouth College*: "Market efficiency does not imply prices cannot change. It does not even say they cannot change by a lot. The key question is whether we should have known the Dow would drop from 14,000 to 7500. Some who made fortunes by anticipating the drop seem to have convinced many observers that the outcome was obvious, but that is just history being written by the victor. Unlike the technology boom of 1999-2000, I don't recall lots of conversations in which people struggled to understand why the Dow was at 14,000. "



I think that taking two recent examples of market crashes and saying that "history [is] being written by the victor", falls far short from making any argument at all. There are plenty of investors/traders, like the already mentioned Buffett and Soros, who have continuously been right AND, more importantly, have beaten the market for many decades. Something that efficient market theory claims to not be possible.


As for the discussion of trading vs investing, I would classify Soros more of an investor who takes technical analysis into account; something Buffett doesn't do. My understanding would be that trading is almost exclusively done based on technical analysis, but as I am not a trader I cannot be certain on this. 
I do know a successful currency trader though, and believe that it is possible to be very profitable at it. The problem is that a lot people think that it should be simple to trade, and there are so many ways for a beginner to just get started using leveraged products AND inevitably lose all their money in a very short period of time; essentially handing over money to those traders that know what they are doing.


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## dubrov (24 Jul 2009)

A few points to throw out there

Investing  (i.e. lomg term positions) and technical analysis are almost a complete contradiction. I haven't read any of Soros' commentary but I can't imagine he talks about investing and technical analysis in the same breath. Also, I don;t think anyone apart from the amateur day trader trades an things like moving averages and fibonacci retracements.

There are certainly inefficiencies in the market. Some are actually riskless but are usually exploited quickly by those who specialise in the relevant areas and eventually disappear.

Guys like Soros and Buffett are highly respected and I'm sure will always push strategies which they will always have positions in. Surely this helps them to outperform the market.


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## darag (25 Jul 2009)

dubrov said:


> I think darag is referring to a subset of this known as "proprietary trading".


Yes, you are correct; I was referring to proprietary trading.  I misrepresented the term "trading".  I guess I should edit my previous posts but it would make the thread very confusing.


			
				EAP said:
			
		

> If so, I couldn’t agree more. But the fact is that Trading (in whatever sense you take it to mean) is not a zero sum game, it is a NEGATIVE sum game. Negative because of the point Brendan makes about brokers etc deducting commissions along the way. If you sit down at a poker table with ten people, some will win and some lose, but the house is the only real winner due to its rake.


I used to think this way but I don't any more.  The poker game analogy seems like a good one when you look at a futures or options market.  A number of "players" exchanging wins and losses with each other while the house/exchange creams off a little all the time.  There is a very fundamental difference 'though; many of the players in the futures and options markets are NOT participating because of the promise of positive expectation - they are hedging and this creates linkages across markets.  This never happens with a poker game - even if you could sit at more than one table at a time, a loss at one table cannot improve your chances of winning a hand at another because each (cash) game is independent.

I could never get my head around what I thought was a paradox; the stock market has positive expectation because companies/capitalism seem to be able to consistently deliver growing profits.  The futures market should be a less-than-zero sum game and yet I can, using futures, buy the EXACT same exposure to the stock market.  If I can expect greater than inflation rates of return from investing in the stock market, how can the purchase of futures (a less-than-zero-sum game) provide me with the exact same return?  The solution is as I pointed out above - all the markets are linked in terms of flows of money.

I don't think Buffet is a good example here; he is neither a trader nor an  investor.  Actually I should qualify that - he is not a passive investor - he often restructures companies he buys/invests in - installing his own management, etc.  This is the work of a smart businessman - not just an investor.

Regarding "largely efficient", I guess I mean the markets have efficiencies but that they are difficult (but not impossible) to exploit.


			
				Chris said:
			
		

> As for the discussion of trading vs investing, I would classify Soros more of an investor who takes technical analysis into account; something Buffett doesn't do.


You sure Soros uses technical analysis?  I'd be very surprised.


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## Rory Gillen (6 Aug 2009)

I might throw my twopence worth in here and hopefully I don't thread on any toes while doing so. I would agree with Brendan and I think Darag has it right too.

Buffett has provided the clearest analogy I have ever come across when trying to distinguish between the investror and trader. Investing is about owning assets, which are supposed to grow in value in the medium to long term. The last 10 years has put a dragger threw that belief and it takes faith to hang in.

The trader is using assets, stock market assets, to scalp. By definition he is doing this over short term horizons. But the markets do not produce wealth in the short term, they do so over the long term as corportae profits rise. In the long term, then, it is not a zero sum game. In contrast, short term trading is a zero sum game, or a negative sum game after costs as Brendan has described it. For example, if we were all to trade the market, and it is a zero sum game, then clearly some of us must lose if others gain. That said, knowledgeable and disciplined traders can make a success out of trading at the expense of the not so disciplined traders. As Buffett himself opined in one of his annual reports, some traders win, some traders lose but like poker no new money leaves the room. 'Way of the Turtles' is a fascinating book on the discipline and difficulties of trading. A vert enjoyable read and a great human story but parts of it are a bit technical. I believe it is still in print and can be bought through most of the online bookshops.


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