Throughout the site, you will notice that I often differentiate between speculating, trading, and investing. In this article, I shall explain the nuances that differentiate the three from each other.
Speculating
Speculators are like hunters in the woods who hear a sound in the trees and fire their gun immediately before determining what made the sound.
Speculators base their buy and sell decisions based on what they feel the market is going to do next in a discretionary, free-form sort of manner. Speculators will intentionally (or even ignorantly) buy overvalued stocks simply because the market is strong and prices keep rising. Speculators are the type of market participants who will buy ZOOM instead of ZM even when they know it’s clearly a mistake because they watched it go up 1,900%. The reasoning behind their risky behavior is always driven by the desire to get rich quick. Historically, speculators – even if they strike it rich – have a tendency to eventually lose all their money on a bad bet.
Investing
Investors are like landlords who want to own great properties that can generate ever-increasing rent.
Investors make buy and sell decisions on stock based on the underlying company’s ability to return cash to shareholders in the future, and not what the stock price is doing. A true investor sees themselves as a partial owner of a business, and is concerned about whether they will eventually receive dividends from the company’s earnings, even if it doesn’t do so in its present form.
Investors are very selective and only own stocks that they would be compelled to buy more of if the price went down.
Investors know their stock holdings very well and have a strong opinion of what they’re worth. Due to their understanding of the underlying company’s ability or potential for returned cash flow, they do not use stop losses but are inclined to buy more stock when prices go down, similar to grocery shoppers who stock up on their favorite items when they go on sale (instead of wondering why the price has been cut.) This willingness to “average down” is a misunderstood practice for outsiders (e.g. some traders mistakenly call it “bag holding” which is another thing entirely), and a deadly practice for inexperienced investors who lack the skill and insight to evaluate a business properly.
Trading
Traders are like real estate property flippers who buy houses at prices they perceive as cheap, which they subsequently sell at higher prices if and when the market permits.
Traders straddle the fence between speculating & investing, and fundamental & technical – depending on the individual. This may be difficult to grasp for some because this makes it harder to know which box to put a trader in.
The main difference between traders and investors is that traders buy and sell primarily for capital gains, NOT the underlying business’ ability to generate and return cash flow to shareholders in the future. While some traders (depending on their style) might understand the underlying business’ ability to generate cash in the future, that knowledge is just a means to an end: an eventual exit for capital gains.
Analogically, investors are like landlords who ultimately desire rent from their properties, and traders are like a property flippers. Based on this definition, stock flippers who specialize in “cigar butts” – like Benjamin Graham, who only cared about what a business was worth dead, or a young Warren Buffett who scoured Moody’s Manuals for undervalued stocks to flip – are actually traders. I don’t know if I’m the first person to suggest that explicitly in writing, but it is crucial to understand the difference between profiting from returned cash flow (e.g. dividends, distributions) and capital gains (money given to you from the market and not the company.)
I believe this distinction between “capital gains” versus “cash flow” is the best way to separate traders from investors – not time frame, use of stop losses, or being bent towards fundamental or technical analysis. Although there is a tendency for traders to have short-term horizons (under 1 year), that’s not always the case – trend followers for example, will hold stocks for as long as they continue to trend favorably. Although there is a tendency for traders to use stop losses, some of them solely use position size – and nothing else – to control risk, or use options which will either be profitable or expire worthless. And there are plenty of traders who use fundamental analysis along with technical analysis.
As far as the difference between traders and speculators, traders aren’t “fire-aim-ready” types like speculators are; they properly go through the “aim-ready-fire” procedure in proper sequence. Whether they use fundamental or technical analysis, traders analyze potential trade ideas and form their own independent opinions. Unlike the emotional speculators, traders do their best to remove emotion from the equation and try to pinpoint objective catalysts.