Are you a ‘trader’ or an ‘investor’ ?

July 9, 2015
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Any person or an institution that purchases any asset in any financial market with an intention to sell it for profit can technically be called an investor. However, there is a huge difference between the kinds of mindsets with which different people or institutions buy and sell assets in markets. While part of the investment decision is rational and may have been strategically thought through, there is a psychological part as well. Since devil is in the details, let’s get into that for the latter part to understand further.

Pic source – niveza.in

When we talk of the psychology of an ‘investor’, using the general connotation of that term, it is completely different from that of a ‘trader’.  The connotations themselves result from these differences and henceforth, we will use the same connotations throughout the rest of this article. The various channels along which these differences manifest themselves, are the following:

Time Horizon (Period of holding on to the investment)

Traders typically look at very short term (intra-day) to short term (a few days) favorable price movements to earn quick profits while investors willing to bide their time and stay invested for long durations (at times forever) to earn returns.

Decision making process

Traders are more likely to look for opportunities where they can exploit the price volatility and shocks. A larger fraction of traders’ decision making is likely to be speculative and intended to take the advantage of momentum of stock movement, which may be positive or negative. ‘Technical analysis’ is widely used to predict such momentums in advance, for quick decision making.

On the other hand, investors are more likely to conduct sufficient due diligence before taking their decisions. They are also more likely to conduct a deeper analysis of the fundamentals to develop a better understanding of the businesses as they usually look for a sustainable competitive advantage.

Time taken for decision making

Traders take their decisions in very short spans of time, typically from split seconds to a few hours. Traders have to be in constant touch with the pulse of the markets as prices can move up or down very swiftly in short durations of time and lead to huge losses on their positions.

Investors are likely to take adequate time before taking either a BUY or a SELL decision. While some individual investors may take a few days of research to make up their mind about an investment, some hedge funds and institutional investors at times are known to spend weeks or even months for completing the research before taking the final investment decision.

Ability and Willingness to take Risks

Traders typically don’t have huge amounts of capital at their disposal. They are likely to adopt high leverage and make money on the back of their agility and decision making speed. High leverage on a low capital base is indicative of their willingness to take high risk.

However, investors are unlikely to use any leverage without having a specific strategic need and have lower willingness to take risks despite having higher capital base at their disposal.

Vulnerability to stress and emotional decision making

Traders have to take decisions quickly and have to constantly monitor the price movements of their active trades which is stressful and at times decisions are made with on the basis of emotions instead of logic. Investors usually tend to take time while taking decisions and are therefore, subject to much less stress, but in their cases too, emotions play a role in decision making

Use of Leverage and Volumes

Traders are always looking for short term opportunities, which are also likely to be small in terms of magnitude in terms of price movement. Considering the transaction costs of buying and selling securities, in order to make significant amounts of profit, traders need to use leverage i.e. trade using borrowed money. However, investors too adopt leverage when it has a strategic role to play in the investment – in ways as exotic as a Leveraged Buy-Out (LBO) OR as simple as purchase of a home using the home loan advanced by financial institutions.

Leverage helps in magnifying the gains, but it can also magnify the losses. Let’s try to understand this with the two examples below:

Case A: Without leverage (no borrowed funds)

 

Case 1: Profit

Case 2: Loss

Trader’s Own Capital

$10000

Buying price of a stock

$10

$10

Selling price of stock

$10.5

$9.5

 

 

 

Number of stocks purchased

$10000/$10 = 1000

Profit/ (Loss) per Stock Unit

$0.5

($0.5)

 

 

 

Net Profit / (Loss)

1000 * $0.5 = $500

1000 * ($0.5 )= ($500)

Net capital post completion of trade

$10000 + $500 = $10,500

$10000 - $500 = $9,500

Net Profit/ (Loss) %

$500/$10,000*100 = 5%

($500)/$10,000*100 = -5%

Case B: With leverage (borrowed funds, with negligible interest#)

 

Case 1: Profit

Case 2: Loss

Trader’s Own Capital

$10000

Borrowed Capital

$40000

Amount available for trading

$50000

Buying price of a stock

$10

$10

Selling price of stock

$10.5

$9.5

 

 

 

Number of stocks purchased

$50000/$10 = 5000

Profit/ (Loss) per Stock Unit

$0.5

($0.5)

 

 

 

Total Profit / (Loss) from trade

5000 * $0.5 = $2500

5000 * ($0.5 )= ($2500)

Total capital post completion of trade

$50000 + $2500 = $52500

$50000 - $2500 = $47500

Total capital available post-returning the borrowed capital

$52500 - $40000 = $12500

$47500 - $40000 = $7500

Net Profit/ (Loss) %

$2500/$10,000*100 = 25%

($2500)/$10,000*100 = -25%

# Assuming negligible interest for simplicity

The examples above clearly indicate that leverage magnifies both profit as well as loss and thereby, increases the inherent risk in the transaction by widening the probability distribution of potential returns.

As a market participant, it’s important to be clear about your investment strategy (Trading or Investing) to be able to pick, develop and maintain your portfolio accordingly. The approach or strategy could be either – trading or investing but it’s extremely important to keep the ‘investor’ and ‘trader’ buckets separate from each other and not mix them irrespective of the performance of your portfolio.

Quick Summary:

A ‘trader’ mindset is significantly different from an ‘investor’ mindset. While traders look to make many small and quick wins, investors are looking for a few long term awesome wins. The process of decision making and inherent risks in these approaches also vary accordingly.

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About the Author
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Amod is a Strategy professional with a combined experience of almost 7 years in Management Consulting and Product Development. He studied Electronics Engineering at IIT-BHU Varanasi and fell in love with Finance and Strategy at IIM Lucknow. He enjoys reading and playing cricket

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