Investing vs Trading:

Why Successful Investing is Easier Than Trading

by

Brad Castro

My own psychological preferences are to acquire at a discount long term quality assets through various option trading strategies and then to manufacture, through other option trading strategies, year in and year out, modest but significant additional returns separate from the performance of the stock itself.

I call this approach Leveraged Investing. Is this the only way to invest? Of course not. Is it the best way to invest? That depends entirely on the individual. I’m convinced that this is the best way for me to invest, and I think every self-directed investor should seriously consider the merits of this approach.

In fact, one of the primary objectives of this site is to promote the idea that certain option trading strategies are not only compatible with conservative, long term investing in quality businesses, but that they’re an ideal match.

Still, I don’t denigrate traders or trading. There are two sides to the investing vs trading question, and I’m fully aware that, from scalp trading to swing trading, there really are individual traders who possess the knowledge, skills, and psychology to earn a real living trading the stock market. But I believe those individuals are the exception, not the rule.

That’s not to say that investing, in contrast, is ever easy. Buying and holding a diversified basket of stocks is effective only during long term secular bull markets (and it’s been quite a while since that phrase has been bandied about). Buying and holding actively managed mutual funds is an even worse way to invest. After factoring in fees, expenses, and overtrading by managers, the average mutual fund actually underperforms the market.

Predicting the Future (of What?)

But I maintain that all else being equal, for the average person, successful investing is a whole lot easier than trading. Why? Because what true investing attempts to predict is far easier to determine that what trading attempts to predict. Although both attempt to predict the future, it’s important to realize that they’re attempting to predict two totally different aspects of that future.

What trading attempts to predict is . . . the behavior of other traders. Technical analysis, trends, candlesticks, chart patterns, moving averages, support, resistance—those are all measurements that track the movement of other traders, not the movement of a stock or index. Or rather, it’s traders’ behavior that generates a stock’s behavior. The share price is the result, not the cause. My sense is that a lot of people operate as though the opposite were true.

Technical analysis becomes more useful when you recognize its purpose and its limitations. In effect, technical analysis is the mathematical graphing and tracking of crowd psychology. From a stock market trading perspective, certain well-documented patterns of behavior have emerged under a variety of historical conditions, and patterns are patterns because they tend to repeat. So if you can successfully identify a pattern as it unfolds in real time—the real purpose of technical analysis—you stand to profit handsomely.

But psychology is not exactly a hard science, and I contend that technical analysis is as much art as it is science: patterns frequently fail to produce the expected results, trends reverse, support and resistance levels dissolve. And there are just too many variables involved for me to ever be comfortable becoming a true practitioner of technical analysis.

Besides, I’ve found something much easier to predict than the mass behavior of strangers with money . . .

What Investing Attempts to Predict

In fact, it’s so simple that most people think it’s difficult. Fundamental analysis is frequently every bit as rigorous and time consuming and mathematically-daunting as technical analysis. There are as many esoteric financial ratios as there are technical indicators, and placing too much of an emphasis on auditing every aspect of a company’s financial statements and SEC filings may not actually be helpful.

You should definitely research a company before investing in it. Due diligence is crucial. But if you’re investing solely on a valuation basis, you may be missing the point. Investing isn’t about identifying and exploiting a price to value mismatch. Buying the stock of a “mediocre” company because it’s trading at a “truly inferior company” price is not investing. It’s trading.

Yes, buying a company for less than its liquidation value has a long and reputable history. This was Benjamin Graham’s “cigar butt” approach to value investing after all, and I wouldn’t for a moment suggest that it’s a flawed strategy. I’m simply saying that it’s more like trading than investing.

If you buy a business that generates little if any profits simply because you can get it at a dirt cheap price, would you really consider this an investment? Isn't it more like prowling garage sales for items you can list on eBay at a higher price?

In my mind, true investing in the stock world is acquiring shares in truly superior companies. Truly superior companies are those that consistently make strong profits, that dominate their industry, that have significant structural advantages over their competitors, that have strong balance sheets, and that will survive in just about any economic environment short of a nuclear holocaust or a giant meteorite destroying all life on the planet.

Businesses that meet these requirements are obviously a small, small minority in a vast universe of publicly traded stocks, but they do exist. Just because they’re small in number doesn’t mean you can’t find them. In fact, superior businesses tend to stand out and when you come across one, you’ll usually know.

[For a related discussion, check out the "Quality Investing" site article.]

Valuation

But this is where our Leveraged Investing option trading strategies come into play. The price you originally pay for your shares doesn’t have to be static. By using options, you can adjust that price downward after the fact. Think of it like getting perpetual rebates.

[For more details, see related articles, "Adjusted Cost Basis with Options" and "Buy and Hold and Cheat."]

So from a Leveraged Investing standpoint, it’s much more important to identify a superior company trading at a reasonable price than it is to identify an average company trading at a significant discount to its intrinsic value. Or, as Warren Buffett himself has famously said, “It’s far better to buy a wonderful business at a fair price than it is to buy a fair business at a wonderful price.”

Final Thoughts

For more information on options-based value investing vs trading, see the related site article, "Value Investing and Options."