Let me ask you a question. Do you consider yourself to be an investor in, or a trader of the stock market?
Over the course of my career I have met literally thousands of people who participate in the stock market. The clear majority of them – I estimate at least 85% – would characterize themselves as investors in the market.
It’s almost as if there is something less dignified about being a trader. Some people associate trading stocks with gambling…now there’s a topic for another post!
Trader vs Investor
Most people think the difference between an investor and a trader is a function of time.
Supposedly investors have long-term time frames and traders operate in the short term.
In reality, the difference between the two is a function of purpose.
Real investors are owners of a business. They buy stock in a company because they understand the business, they believe they’re buying in at a fair price, they look forward to participating in the profits of the company over many years and intend on holding the shares for a long time, maybe indefinitely.
Everyone else is a trader!
Real traders understand that trends in markets exist because of strong human emotions. They buy and sell stocks because fear and greed create opportunities to profit from the identifiable patterns that form within trends.
In other words, traders buy a stock because they expect to be able to sell it later at a higher price.
If that sounds like you, well my friend you are a trader just like me. This notion may jar with you because of your perception that traders are short term, traders are all in a hurry etc. These perceptions have been perpetuated by the ill-informed.
It’s an important distinction because most people like to think of themselves as investors – which is probably why many people have a tough time navigating the stock market.
The fact is, most people are traders – and they get into trouble when they don’t recognize it.
If you’ve ever bought or sold a stock based on emotion, you’re a trader.
If you check the value of your holdings every day, every week, or every month, you’re a trader.
If you’re pondering how this quarter’s earnings will affect a stock’s price, you’re a trader.
If you wonder how markets will react to next month’s Nonfarm Payrolls number, you’re a trader.
If you think you should sell CBA and buy NAB “because it’s cheaper”, you’re a trader.
We all like to think that we can make rational, logical decisions unaffected by emotion. These are the characteristics of a good investor – but they apply to very few of us.
Indeed, conventional financial theory suggests that investors are rational and seek to maximize profit through objective, non-emotional investment decisions. That makes sense. Nobody invests with the goal of losing money.
However, the emotions of fear and greed, along with herd instinct, have always been the main drivers of stock prices and investor behavior, and these lead people to make irrational investment decisions. This very thinking has given rapid rise to the field of behavioral finance.
Emotions and the Ego
Many people who think they’re good investors will buy into a stock based on logic and sound reasoning. However, after they’ve bought in, they will often succumb to the emotions of fear and regret, and end up selling winners and hanging onto losers.
There is an old saying that investors like to toss around that goes along the lines of: “You never make a loss until you sell”. It is often offered as if it was a nugget of wisdom. Really, it has more to do with the ego’s reluctance to face up to the regret of loss.
Other times investors will get a solid gain on a position, but will refuse to take profits…even if it has met their wildest expectations. Often, they will find new reasons to hold on as greed – fear of missing out – has taken over and they don’t want to leave potential gains on the table. The ego also likes to see that they have been clever enough to have bought a stock that now has a nice unrealized gain.
You can see the potential negative effects the emotions of fear and greed can have on the average investor’s returns, if they are not aware of and in control of these emotions.
Whether they like admit it or not, most participants in the stock market are traders.
A good trader knows that when it comes to markets, emotion will often override logic. She can spot emotional extremes in the market and exploit them for profit. More importantly, she is aware of her own emotions and has rules in place to keep them in check.
To be a profitable trader, you must follow a robust set of trading rules and develop strong risk management discipline and you must do so with consistency. This will take emotions out of the equation as much as possible and keep you on the right side of the market.