Stock Trader or Investor?

Stock Trader or Investor?

Be Both a Short-Term Trader and a Long-Term Investor

By Dr. Winton Felt

Do short-term traders assume more risk or less risk than long-term investors? Does selling quickly when an overpriced stock breaks down make a person a trader? If so, is that a bad thing? If you read between the lines in the financial press, you will find that it is the “traders” who profit from short swings in the market and from market volatility. Note how often it is that when there is a significant market surge, the announcement is made that “traders snapped up oversold stocks today and the market surged” or “traders sold to take profits from the recent market rise.” The real issue should not be whether a person is a trader or investor. It should be whether or not his enterprise is making money. Some in the industry do treat the term “trader” as if it represented something evil. Why? Though they have concocted a rationale for a pejorative treatment of the word, it seems to come down to money and the naysayer’s fear of losing it..

For example, the mutual fund industry has tried to indoctrinate investors to believe they should always “invest for the long term.” While there is some truth in this with regard to mutual funds, errors (and portfolio disaster) can result from applying the same thinking to individual stock investments. Fund companies do not want investors to sell their mutual funds…ever. If the manager does a good job, there is no need to do so. However, if the manager of the fund’s portfolio holds every stock position in his fund long-term as a standard procedure, it is extremely unlikely that he will do an outstanding job, though he might do so relative to other fund managers (who also use the same approach). The reason “trading” has become a pejorative term to the fund industry is similar to the reason all commercials on television occur at the same time. Broadcasters are afraid that if their commercials were aired at different times from the others, they might lose the viewers who switch channels during commercials. Likewise, mutual funds don’t like “timers” and “traders” because they threaten a fund’s source of consistent revenue. They want their investors to stay put. However, mutual funds are not totally unjustified in saying that investors should hold their funds for “the long-term.”

Fund managers know that individuals (trying to ride out the “bumps”) tend to hold on until the pain is too much to bear. The average investor panics only after the market has fallen about as far as it will fall. That is when fund managers would prefer to do a considerable amount of buying. However, individual investors are pulling their money out of funds at that time. The fund managers must therefore liquidate assets at low prices in order to generate the money needed to buy all the shares being dumped by shareholders (fund shareholders sell their shares back to their fund and not to other investors). When the market is high and has become risky, fund managers prefer to maintain a larger cash position. However, that is the time individuals pour money into the funds causing a glut of cash. Fund charters (charters define how a manager manages) may limit the amount of fund assets that can remain in cash. Therefore, the manager may have to buy large quantities of stock when he would prefer to be selling. In other words, the behavior of individual investors (investing when stocks are high and selling when they are low) has a significant negative impact on the performance of fund managers who could do a much better job if investors would simply stay put instead of trying to “time the market.” Timing the market is an activity for which most investors are poorly equipped. The managers are being forced to behave like the amateurs who invest in their funds. Managers therefore admonish investors to hold for the long-term. They repeat it in every TV interview and in every financial publication where they are quoted: “do not be a trader, hold for the long term; that is the only way to invest wisely.” Managers are simply saying, “stay put and let us do our job.” The fund managers are right. Ninety-five percent of fund investors should stay put and let the fund manager make the decisions.

Brokers have different reasons for using the word “trading” in a pejorative sense. Clients who trade will not stay with a “full service” broker because the broker doesn’t have time to monitor positions let alone manage change in Client portfolios. That’s why they steer clients to “managed accounts.” They can keep clients in these “managed accounts” indefinitely simply by switching them from one manager to another if performance is “unacceptable” to the client. The broker gets his 1% out of the client simply by conducting an interview with that client once or twice a year to gauge his or her satisfaction with performance. The brokerage firm also gets its fee and the money manager gets a fee. Everybody profits, except perhaps the client. The broker is a trained salesman, not a portfolio manager. The brokerage firm wants its brokers to sell investment “products” that are not a drain on the broker’s time. The more time brokers spend screening stocks, the less time they will have to maintain an acceptable level of “production.” Brokerages do not want their “advisors” to be true money managers. They want them to gather assets and generate revenue by selling the firm’s pre-packaged products (mutual funds, managed accounts, annuities, etc.).

Money management is a time-consuming endeavor. For example, when was a registered investment advisor and I was a portfolio manager, I could manage a $100,000 portfolio for an entire year and generate $1500 in fees for the effort. Out of that, I had to pay for data-feeds, software (this came to many thousands of dollars with ongoing annual fees), office help, utilities, subscriptions, equipment, and so on. There was also a huge amount of study time and monitoring time required. When I was a broker for one of the largest brokerage firms in the world, I could sell one mutual fund to a client who had $100,000 to invest and earn $4000 in commissions in one day. Of the $4,000 I might keep nearly half and my firm would get the rest. Then I could forget about that client and look for the next prospect. If clients called with concerns about their investment, I was supposed to simply say “we are in it for the long term; we are not speculators or traders.” That way, I would not have to think about their investments, and I could go back to selling. I wouldn’t need any data-feeds or fancy equipment to do this. My overhead would be minimal. What brokerage firm would want its “advisors” to manage money? As a “product pusher,” I could generate nearly three times the income on the same amount of assets in a single day as a money manager makes in a full year! Firms want their advisors to sell, not manage. Therefore, it is to their advantage if a client will stay put. It is even more to their advantage if the client is invested in one of the firm’s proprietary mutual funds, because they generate ongoing fees that are automatically deducted from the client’s assets when net asset value is calculated.

Sometimes the flexible investor will act like a trader and sometimes he will act like a long-term investor. An investor might hold a stock for 3 years and capture a 25% gain. As a trader, I have locked in that kind of gain in a few weeks. On one occasion, as an advisor acting on behalf of my clients, I locked in a 26.7% profit in Apple after holding it for less than 3 months. Does that mean I was acting “foolish,” acting like the “speculators,” or “risk-takers” in the market? My clients did not think so. If we had held it for several years to get the same return, would we then have become “wise” investors? Apple started to show weakness and we had a large gain. At the time, we did not know whether the stock would resume its upward path after only a 5% drop, so we sold without waiting to see. Why take the risk necessary to wait and see how far it would decline? My thinking was that we could always buy it back if it should appear to be strong enough to generate an additional profit. In the meantime, we had removed our profits from a risky situation and we even saved the time and the 5% or more it would have cost us to find out if the weakness was only a “dip” or the beginning of a “plunge.” When I sold, I did not know how far Apple would drop. In fact, it fell 14.5%. After the decline, we repurchased the stock.

The real issues are risk and return. We want to minimize one and enhance the other. Sometimes “trading” is precisely the way to accomplish those ends. The key here is not the percentage gain or loss or even the holding period. It is the risk involved in maintaining the position. For example, a stock that closes 3% below support may subject a portfolio to the risk of an additional 20% decline (the distance to the next band of significant support). Therefore, it may not be so much the 3% drop that causes a sale as the fact that nearby support was inadequate to stop the decline, and that there is no more help in sight until after a much larger decline. However, a stock that “behaves itself” may be held for a gain of 25% or more.