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Avoid playing trader if you are an investor

Ups and downs: investors and traders treat market fluctuations very differently

At the risk of overstating the obvious, there are important differences between traders and investors. Their timelines differ, as do their goals, preferred assets and methods. Yet some of what I have been hearing from members of each group suggests they themselves can sometimes become confused about these dissimilarities. Blame the recent market volatility for this.

Because of my background, I understand both perspectives: I began on a trading desk, where I did pretty well, if you ignore the several times I nearly blew up. Not just money-losing months — all traders suffer through those occasionally. I mean total destruction. Those experiences sent me searching for a better understanding of investor psychology, into a decade-plus doing sell-side research, and ultimately, to the buy side as a money manager. So I’m familiar with both sides of the aisle, whether it is as a short-term trades or a long-term asset manager. That lets me spot the trouble that arises when I see folks dancing back and forth over that line.

It is an old cliché because it’s true: Traders should never let a bad trade turn into an investment; investors should never try to trade in and out or time the markets.  

A quick review explains why: When a trader holds onto a position that has gone against him it reflects a failure of risk management. No trade should ever be entered into without a clearly defined exit strategy, both up and down. Staying with a losing trade is an admission that simple risk-management rules are being ignored. The triumph of hope over experience isn’t a strategy; it’s a recipe for more losses.

The trader’s job is to manage capital to optimise profit for a given level of assumed risk. Tying up capital is problematic to begin with, but ignoring one’s own risk-management rules is trading suicide.

The flip side of this is the long-term investor who suddenly believes he can easily and suddenly shift roles, become a cowboy and put on the professional trader’s hat for fun and profit.

Just as our trader’s lack of risk-management discipline will cost his returns, capital and possibly his career, so too will our investor who suffers the consequences of his market-timing dabbling. The investor lacks the temperament for the ups and downs of daily market action. He — and most of the time, it’s a he, not a she — is used to a longer timeline, slower turnover, lower taxes, smaller fees. His folly is the arrogant assumption he can adapt and exploit whatever those dumb traders are doing. Huge mistake. The results invariably are that clients leave, assets under management plummet and future income is impaired. Other than that, it’s a brilliant plan.

The truism for all diversified investors is that they are not really diversified if they don’t hate something in their portfolio at the moment. Trying to avoid that simple reality by jumping in and out — a trick investors are not qualified for by either dint of their DNA, experience, or philosophy — doesn’t seem to dissuade them. The obvious disadvantages of those costs, taxes and turnover mentioned earlier are ignored. But the emotional risks are even greater.

What starts to happen to the investor who has morphed into a trader is that he believes he is right and everyone else is wrong. Getting out of the market and avoiding a 15 per cent decline feels good, but not having a re-entry plan can be disastrous. I have seen countless investors who managed to pull out before the collapse in 2008-09, but then fail to reinvest. It happened in 2000, it happened in 2008 and it happened in 2011.

Missing a 200 per cent rally in the Standard & Poor’s 500 Index and riding gold down because the Federal Reserve is going to stoke hyperinflation and debase the dollar is a classic example.

Perhaps the most infamous version of this was famed market-timer Joe Granville in the late 1970s and early 1980s.

Sitting out a 1,000 per cent rally that spanned most of the next two decades is a career risk they hardly discuss in business schools, but Granville did just that.

The bottom line remains simple: stick to what you do best. If you are a trader, then trade. Use your capital, let your winners run, cut your losers short. If you are an investor, understand that you have a much easier job — except for your own behavioural issues.

The sooner people figure that out, the better their portfolios and returns will look.

Barry Ritholtz is a Bloomberg View columnist.