By Nicholas Colas of DataTrek Research
Even the most committed long-term investor can learn a thing or two from how traders go about their process. The core tenets of trading are: 1) respect price action, 2) manage risk so you can meet your goals, and 3) maximize the impact of your time and attention. The last 2 days tell us US/global equities still have a slog ahead of them. The only goal now, for investors and traders alike, is to make it to the turn in asset prices (whenever that is) with the least amount of incremental damage to portfolios. A little bit of traders’ discipline can help.
Ever since I (Nick) started on Wall Street in the mid 1980s, there has been a bright line between "traders" and "investors." The stereotypes for each tell the story. Traders are momentum-chasing volatility addicts. Investors buy and hold no matter what the tape is saying.
I have worked for and with individuals who have made billions of dollars for themselves and their investors following one or the other approach, so I am not much of a fan of these labels. Many people point to the fact that Warren Buffett is wealthier than any trader as proof that investing beats trading. Fair enough, but as Barron’s recently pointed out, Buffett made 90 percent of his money after age 65. His edge in the global wealth league tables is just as much about longevity as investment acumen. He has been blessed with both.
One reason professional traders and investors are so different is due to their training. This was the approach when I got to SAC Capital in 1999:
- You start with a base of capital, say $1 million.
- Your goal is to make $1,000/day, every day, on that capital. This works out to a 25 percent annual return. Not a crazy amount, but well more than the S&P’s typical 7-10 percent return. And when I say “every day” that is exactly what I mean. Every day, no excuses.
- Once you can reliably make $1,000/day for 4-6 weeks you up the goal to, say, $1,500/day.
- If you stumble at $1,500/day, you go back to the $1,000/day goal. Once you make that for a few weeks, you try again to hit the higher target. The process then repeats. Eventually, you add more capital to the original $1 mm base and set ever-higher goals.
This is nothing like the typical training for an “investor”. The usual path for them combines education (MBA or CFA preferred, as the help wanted ads often say) and on the job training. Many investors start as industry analysts, then run a sector portfolio, and finally a diversified book. I did the first part of this path myself, getting an MBA and then working as an industry analyst at Credit Suisse for 9 years. Only then did I go to SAC and undergo the training described above.
I can tell you from those first-hand experiences that the difference in training leads to very different decision-making pathways for “traders” versus “investors”. A few simple examples:
- Show a trader a stock making a 52-week low, and they’ll be inclined to short it. The investor, on the other hand, will be more inclined to want to buy it. Most stocks do not go to zero, they reason, so a “cheaper” stock may have better future return prospects.
- If a trader owns a stock that drops 3-5 percent in a day, they will almost certainly sell it right there. That loss is a hit against their daily profit target, so selling clears the mental decks and provides the capital to focus on making that money back in other names. The investor is more likely to think that “the market has it wrong”. See Cathie Wood’s endless defense of her major holdings in the ARKK ETF for a case study in that way of thinking.
- Traders focus on high conviction ideas – those that have the best chance to deliver their daily profit goal. They don’t need to have a perspective on anything else. Investors face a more wide-ranging challenge. Most are broadly diversified, which means they need a high level of competence across a wide array of asset classes, geographic regions, sectors, and stocks.
The point here is not that trading is “better”, but that in challenging markets even the longest-term investor can use a trader’s discipline to achieve better results. A few examples:
- As we have said many times of late, avoid holding on to new 52-week lows and certainly be very careful considering any stock or ETF that has recently made one. Wait for the price to level out for 1-3 months at least. Cheap stocks and sectors always get cheaper when markets are resetting valuations lower.
- Scale risk exposure based on the CBOE VIX Index. When it gets to 36 (or, even better, 44 or 52) consider adding some risk. When it gets closer to 20, lighten up.
- Focus only on future returns. Even the most novice trader does this by keeping to their $1,000/day goal. The hardest thing about making good investment decisions in a bear market is acknowledging prior mistakes, selling, and moving on.
- Stocks don’t love you back. That’s an old saying among traders, and it is equally true for long term investors. It is easy, but wrong, to think that a stock or sector will work just because you’ve done a lot of work on it or think the CEO is a genius.
The bottom line here is that trading emphasizes the importance of goal setting, following a disciplined process and embracing intellectual honesty – all essential habits for sensible investing in volatile markets. Traders may come across as less intelligent than investors, but their approach acknowledges that managing capital is ultimately about managing your time and emotions. “Investing”, grounded in academic theory, skips over those all-too-human considerations. That’s fine in a bull market, but in a bear market a more realistic approach is essential.
Final thought: if you read these comments as a sign we think US/global equity markets have further to fall, you are correct. The good news, after a fashion, is that there will be some fantastic money to be made when asset prices turn around. The only goal now for investors should be to get to that point with a minimum of incremental damage to their portfolios.