Are you a trader or an investor?

Please note: All data referenced in this article are sourced from Bloomberg unless otherwise stated, and is accurate at the time of publishing.

Key Points

• After a five-month rally in US equities, a sell-off might just be round the corner. Surprise events in the Middle East or shock election results are just two reasons that could rock financial markets and upend investors’ goals 
• However, making short-term portfolio trades to try and profit from such events carries its own dangers, not least from unwise knee-jerk reactions. For longer-term investors these can be costly
• In contrast, building a well-diversified portfolio – strategically and with flexibility – is key for long-term investors. This approach can enhance returns, while providing peace of mind
• Striking a balance between avoiding impulsive short-term trades and maintaining a “buy-and-hold” approach can help you control your behavioural biases and achieve your investment goals 

After the significant rally in US equities since October, there’s recently been a pullback. The S&P 500 is down 4.3% in the last month, while the NASDAQ Composite has fallen some 6%. The latest quarterly earnings season will be very significant for both indices.

Last month, we discussed the importance of staying invested in Fear of heights: Investing at all-time highs  and against a slowing macroeconomic environment, due to economic fundamentals being a long-term driver of financial markets. 

A recent dip, or expectations about future sell-offs due to factors such as geopolitics or elections, can lead to a spike in trading, as a way to maximise or to reduce risk.

This article explores the differences between trading and investing, and why a mix of both approaches might be worthwhile when seeking long-term success.

The trader

Traders focus on short-term profits, whereas investing generally aims to provide long-term gains. A trader’s mindset typically involves looking for short-term opportunities, which may be created by changes in economic data and sentiment. This may involve continually evaluating the incentives offered in different parts of the market relative to a range of plausible outcomes.

For example, in the midst of a sell-off, a trader may feel that equities are oversold and overweights possible negative scenarios instead of having a more balanced view of potential scenarios. A trader might also add exposure to markets, seeking to prosper from a reversal in valuations once sentiment improves.

The investor 

An investor, on the other hand, could view success in protecting and growing their assets over several years as being determined by how they allocate their assets and the quality of strategy in doing so.

This approach is generally based on a view of how different investments are likely to perform over a given time frame. It is built on the premise that a well-diversified portfolio that aims to weather the full range of market conditions can provide a larger chance of success than trying to avoid the next downturn.

The investor tends to be less focused on short-term events and news flow, ignoring potential initial hits to valuations, which are not expected to be material for a diversified portfolio held for many years. A portfolio diversified across asset classes, geographies and sectors is unlikely to fully experience the impacts of knee-jerk market moves.

Doing too much can be costly…

The difficulties of trying to time the market were discussed in ‘Waiting for a tipping point’. While being either an investor or trader can produce financial gains, in markets, as in all aspects of life, there can be too much of a good thing.

Over-trading creates risks. First, not every call will go to plan. Indeed, markets can behave very differently to how we expect, based on the headlines. Second, a trading mindset can lead to behavioural biases in decision-making, which while not always visible to the trader, can be a drag on returns.

Behavioural studies show that investors who hold popular stocks directly pay a significant penalty for active trading. Overconfidence often ups trading levels and results in poor performance for some investors.

…but so can be doing too little

Renouned investor Benjamin Graham said, “The best way to measure your investing success is not by whether you’re beating the market but by whether you’ve put in place a financial plan and a behavioural discipline that are likely to get you where you want to go¹.” 

While a focus on the long term may protect an investor from the potential risks and costs associated with making short-term market calls, not giving enough weight to short-term signals can also be dangerous. 

Missing out on potential additional returns from seeking to profit from short-term moves, however small the percentage gain foregone, compounds over time. Because these foregone returns might be difficult to observe, we might give them less weight. However, they can hit cumulative portfolio returns far more than we initially thought.

As asset values change, an asset allocation can shift markedly from what was originally planned by the investor, if it is not managed correctly. A buy and hold portfolio can then become more concentrated over time on its own, with implications on risk and return. 

Striking a balance

One of the best ways to improve your long-term success is to follow a robust and flexible investment approach. Perhaps one which strikes a balance between long-term thinking to generate the core investment returns, with more reactive and opportunistic short-term allocation tweaks to maximise overall returns. 

This is known as a core-satellite approach. The core portfolio is built on an asset allocation that is created for the long term. A satellite portfolio can then complement the core portfolio to enhance returns or mitigate risks.

An investment process that creates a diversified portfolio and invests in quality assets should make it easier to stay invested through stormy markets, while resting more easily at night, and to reap the benefits of time in the market. It can help an investor to protect themselves from acting unwisely in what may be unnerving market conditions.

This year, as in others, looks like being particularly volatile in the financial markets. A forthcoming US presidential election and flashpoints in the Middle East and Ukraine are just two potential sparks that could spook investors. The key to investing during such events is to take measured actions; small tactical tweaks rather than trading an entire portfolio.