The Trader and the Investor
How do you see the stock market? Clearly there is one thing everyone would agree with: the stock market is a place for building wealth. It's the method for building wealth that varies greatly among those that take part in it.
The fact is that there are 2 fundamentally very different ways to approach making money in the stock market. For the purposes of this article, we will look at two very different stock market participants: the Trader and the Investor. Both of these guys are looking to make money through the stock market. But their methods vary greatly. Let's compare the outlook, prejudices, and methods of these two participants and then comment:
|Criteria or Question||Trader||Investor|
|What is a stock?||A chance to "play" the market's idiosyncrasies or expected short-term conditions to make a quick buck.||A small piece of ownership in a business.|
|What is your time frame for holding a stock?||Short-term. As short as a few hours, most common period 3-6 months.||Long-term. At least one year, most common period 2-3 years, sometimes willing to hold indefinitely.|
|When should you buy a stock?||Decision based on price momentum. Buy near the "support" level for the stock price, which is usually an average low over a period of time. Also, buy stocks that have recently outperformed the market (relative strength).||Buy when the stock price is cheap relative to business metrics such as earnings, sales, book value, or cash flow.|
|When should you sell a stock?||Sell at the high end of the stock's price range, which is usually an average high over a period of time.||Sell when the stock price is rich relative to business metrics such as earnings, sales, book value, or cash flow.|
|Motto||"The trend is your friend."||"Buy good companies at cheap prices."|
|Godfathers||Charles Dow, Ralph Elliott, William Gann||Benjamin Graham, Warren Buffett, Philip Fisher|
|Disciplines||Technical analysis, behavioral finance, price chart analysis||Fundamental analysis, quantitative/qualitative analysis, accounting|
|Important Statistics||Moving average, relative strength, support and resistance level, trading volume||Price-to-earnings ratio, price-to-book, price-to-sales, free cash flow, return on invested capital|
|Proof of Effectiveness||Unclear. Little concrete evidence of systematic market outperformance||Numerous historical studies confirm success of investing based on low price to metric ratios|
At MagicDiligence, we follow the Magic Formula Investing strategy devised by successful hedge fund manager Joel Greenblatt in his book The Little Book that Beats the Market. Magic Formula Investing clearly falls under the Investor category above. It uses two fundamental business statistics: earnings yield (the inverse of price-to-earnings) to find cheap stocks, and return on invested capital to find good companies. Combined, the net effect is finding "good companies at cheap prices"... the motto of the Investor. MagicDiligence adds value to Magic Formula Investing by doing deeper fundamental analysis when choosing Top Buy picks, weeding out the companies with sustainable high return on capital figures and throwing out fad stocks, unpredictable commodity stocks, and companies in dying industries.
The last row of the table above illustrates the reason why you should choose the Investor path when building wealth in the stock market. Overwhelming evidence shows that, over the long term, those following the path of the Investor are much more likely to be successful in the market. History is littered with successful people following these tenants, including Warren Buffett and Charlie Munger, Benjamin Graham, T. Rowe Price, Shelby Davis, Philip Fisher (and his son Ken), and so on. While the allure of making a quick profit using technical analysis is undeniable, the list of people who have ridden it as a wealth building strategy is extremely short.
It's important to point out that technical and fundamental investing is not a black and white distinction. Most professional investors use the principals from each when making investment decisions, although they tend to lean more heavily towards one of the two distinctions. While this makes sense in theory, the fact is that balancing too many statistics when choosing stocks rarely provides more value. As James O'Shaughnessy points out in his investing strategy analysis book What Works On Wall Street, using two criteria when limiting your universe of stocks enhances returns greatly, but using more than that actually decreases returns. In effect, the classic K.I.S.S. ("keep it simple, stupid") advice is applicable to investing as well.
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