Selection of rules for investing and trading
There are three important differences between investing and trading. Ignoring it can lead to confusion. A novice trader, for example, may use the terms interchangeably and misapply their rules with mixed and unrepeatable results. Investing and trading become more effective when their differences are clearly recognized. An investor’s goal is to acquire long-term ownership of an instrument with a high level of confidence that its value will continually increase. A trader buys and sells to capitalize on relative short-term changes in value with a somewhat lower confidence level. Goals, time frame, and confidence levels can be used to outline two completely different sets of rules. This will not be an exhaustive discussion of those rules, but it is intended to highlight some important practical implications of their differences. Long-term investing is discussed first, followed by short-term trading.
My mentor, Dr. Stephen Cooper, defines long-term investing as buying and holding an instrument for 5 years or more. The reason for this seemingly narrow definition is that when investing long-term, the idea is “buy and hold” or “buy and forget.” To do this, it is necessary to remove the emotions of greed and fear from the equation. Mutual funds are favored because they are professionally managed and naturally diversify your investment across dozens or even hundreds of stocks. This does not refer to just any mutual fund and it does not mean that one has to stay with the same mutual fund the entire time. But it does imply that one remains within the investment class.
First, the fund in question must have a proven annual earnings history of at least 5-10 years. You must be sure that the investment is reasonably safe. You are not continually watching the markets to take advantage or avoid short-term ups and downs. You have a plan.
Second, the performance of the instrument in question must be measured in terms of a well-defined benchmark. One such benchmark is the S&P 500 Index, which is an average of the performance of 500 of the largest and best-performing stocks in the US markets.Looking back to the 1930s, over any period of time. 5 years, the S&P 500 Index has gained in price about 96% of the time. This is quite remarkable. If you expand the window to 10 years, you find that during any 10-year period, the Index has gained in price 100% of the time. The S & P500 Index has gained an average of 10.9% annually over the last 10 years. Therefore, the S & P500 index is the benchmark.
If you only invest in the S & P500 index, you can expect to earn, on average, about 10.9% per year. There are many ways to enter this type of investment. One way is to buy the SPY trade symbol, which is an exchange-traded fund that tracks the S & P500 and trades like a stock. Or, you can buy a mutual fund that tracks the S & P500, such as the Vanguard S&P 500 Index Fund with a trade symbol VFINX. There are others too. Yahoo.com has a mutual fund rater that lists dozens of mutual funds that have annualized returns greater than 20% for the last 5 years. However, an attempt should be made to find an evaluator who provides performance for the past 10 years or more, if possible. To put this in perspective, 90% of the 10,000 or so mutual funds that exist do not perform as well as the S & P500 each year.
The fact that 10.9% is the average return on the market over the last 10 years is even more remarkable considering that the average return on bank deposits is less than 2%, the yields on Treasuries at 10 years are roughly 4.2% and 30-year Treasury yields are just 4.8. %. Corporate bond yields approximate those of the S & P500. However, there is a reason for this disparity. Treasuries are considered the safest of all paper investments, as they are backed by the United States government. FDIC-regulated savings accounts are probably the next safest, while corporate stocks and bonds are considered a bit riskier. Savings accounts are possibly the most liquid, followed by stocks and bonds.
To help you gauge the question of safety and liquidity, long-term bondholders are comparing the yields on the bonds they now receive with the expected equity yields for the coming year. Consider that the anticipated return of the S & P500 for the next year is around 4.7% based on the reciprocal of its average price / earnings (P / E) ratio of 21.2. However, the 10-year annualized return of the index has been 10.9%. Bondholders are willing to accept half of the stock’s historical performance for added security and stability. In a given year, stocks can go up or down. Bond yields are not expected to fluctuate much from year to year, although they are known to do so. It is as if bondholders want the freedom to invest in both the short and long term. Therefore, many bondholders are traders and not investors and accept a lower return for this flexibility. But if you’ve decided once and for all that an investment is long-term, high-yield equity mutual funds or the S & P500 index, by itself, seem like the best way to go. Using the simple compound interest formula, $ 10,000 invested in the S & P500 index at 10.9% per year becomes $ 132,827.70 after 25 years. At 21%, the amount after 25 years is more than $ 1 million. If in addition to averaging 21%, only $ 100 a month is added, the total amount after 25 years exceeds $ 1.8 million. Dr. C. rightly believes that 90% of one’s capital should be allocated to several of those investments.
Now that you’ve allocated 90% of your funds to long-term investments, that leaves you about 10% to trade. Short to medium term trading is an area most of us are most familiar with, probably due to its popularity. However, it is significantly more complex and only about 12% of traders are successful. The trading period is less than 5 years and generally a couple of minutes to a couple of years. The typical probability of being in the right direction of a trade approaches an average maximum of around 70% when using a proper trading system to less than about 30% without a trading system.
Even at the lower end of the spectrum, you can avoid being wiped out by managing your trade size to less than 4% of your trading portfolio and limiting each loss to no more than 25% of any given trade while letting your winners run up. that decrease by no more than 25% from their peak. These percentages can be increased after there is evidence that the probability of choosing the correct direction of a trade has improved.
Intermediate-term trading relies more on fundamental analysis that attempts to place a value on a company’s stock based on its history of earnings, assets, cash flow, sales, and any number of objective measures relative to current price. of actions. It can also include future earnings projections based on news of trade deals and changing market conditions. Some refer to this as a value investment. In either case, the goal is to buy shares in a company at bargain prices and wait for the market to realize their value and raise the price before selling. When the stock is priced fairly, the instrument is sold unless there is continued growth in the value of the stock, in which case it moves to the investment category.
Since trading depends on the changing perceived value of a stock, your trading time frame should be chosen based on how well you are able to detach yourself from the emotions of greed and fear. The better the emotions can be removed from the trade, the shorter the period of time in which you will be able to trade successfully. On the other hand, when you feel waves of excitement before, during, or immediately after a trade, it’s time to take a step back and consider choosing your trades more carefully and trading less often. One’s ability to remove emotions from trading takes a lot of practice.
This is not just a moral statement. A whole universe of what is called technical analysis is based on the aggregate emotional behavior of traders and forms the basis of short-term trading. Technical analysis is a study of the price and volume patterns of a stock over time. Pure technicians, as they are called, claim that all relevant news and valuations are embedded in the technical behavior of a stock. A long list of technical indicators has been developed to describe the emotional behavior of the stock market. Most technical indicators are based on moving averages over a predefined period of time. Indicator time frames should be adjusted to fit the trading time frame. The subject is too extensive to do it justice in less than several volumes in print. The lower level of trust involved in trading is the reason for the large number of indicators used.
While long-term investors can confidently use only a long-term moving average to track constantly rising value, traders use multiple indicators to deal with shorter time frames of oscillating value and higher risk. To improve your results and make them more repeatable, consider your expectations of change in value, your time frame, and your level of confidence in predicting the result. Then you will know which set of rules to apply.