Market Wisdom. Trader or Investor 2 ... How to find out...

How do I know if I am a trader or an investor ?

Well it is almost a wrong question. The right way to ask the question is how to identify if the decision to buy (or sell) a stock is an investment decision or a trading decision ?

Will the duration of holding determine if it was an investment or a trade ?

Answer is No, there can be trades which last for weeks and months even years together. And there can be investments that are squared off within days or weeks even. Though, generally shorter horizon of holding is perceived as trading and longer format is perceived as investment.

Will the tax liability determine if it was an investment or a trade ?

Maybe the regulation may have some definitions to classify for tax purposes. However, tax kicks in after the exit from the position and not prior to it. Even then, taxation is not the right basis to classify an action as investment or trade.

Will the instrument determine if it was an investment or a trade ?

To some extent, the instrument decides the frequency of your actions.

Generally futures and options (at least in India) have limited life 3 months and therefore require regular exit and re-entry giving rise to a trading mindset. Within cash equities, in India only long positions are allowed, and short positions are feasible only intraday or STBT.

However, within a long position, the instrument is not relevant to classify an action as a trading position or an investment position.

Then what exactly determines it a position is an investment or a trade ?

Whether a position is an investment or a trade depends on the process you followed BEFORE taking up the position. 

Did you look at the Balance sheet, cash flow statements, industry, macros, growth prospects, management quality  … or in short … did you analyse the business and try to estimate a fair value of the stock ? And then decided you wanted to own a part of this business below the fair value as you found its prospects attractive. 

If yes, then your position is business focused and therefore an investment decision.

If you did not look at the financials and other fundamental aspects but you analysed the price, the trend, the 52 week high/low, support and resistance, Gann numbers, fib numbers etc. Based on your analysis, you derived an entry price and exit price for the stock in question.

Your motivation to take the position is based on favourable price action.  And your position is a trading position. 

I have a position and I did not analyse anything but relied on my friend/broker/tip provider. If this is the case, then the bitter truth is you are probably a speculator who is trying to get rich easily and quickly. And my guess is that you will have your share of successes and failures … but will be confused at whatever is happening to your capital. You will not feel in control and you will depend on your most reliable friend or mentor to guide you every step of the process. If your mentor is a seasoned trader or investor and does the homework on your behalf you are very lucky. If not, probably you are confused and lost.

Why is it important to know if a decision is a trading decision or an investment decision ?

Stocks are unique instruments in that there are widely publicised prices which fluctuate based on demand and supply. And these price fluctuations create excitement (when the price is moving favourably) and anxiety (when the price is moving against our position).

So does gold price fluctuate daily. However, why does that not create the same anxiety or excitement ?  Firstly in India we view gold as a hedge and buy to hold forever. Hence the daily price fluctuations does not create emotional trauma for us. Secondly we are happy if we can get gold for a lesser price and not worried that the xxx grams of gold in our custody has lost its value. Because gold is a physical commodity with a totally different value proposition.

So how do we insulate ourselves against stock price movements that creates emotional imbalance in turn leading to wrong decisions. The simple answer is to follow a process before taking up the position. Whether you follow the fundamental analysis or technical analysis, you will have a thesis before you take a position. That thesis will have assumptions, and projections and certain key milestones.

This thesis helps to anchor our position. The conviction about our thesis will help to reduce the excitement or anxiety of price fluctuations. Without such an anchor there is fear or greed which takes over and leads to irrational decision making (like booking a profit too early or not booking a loss even when the market has proved the entry thesis wrong).

Making right decisions

In short, entry decisions are easily made with or without analysis, but exit decisions are tough to make because money has been committed and the profits or losses are too real to ignore.

If your decision was an investment decision, then you review your investment thesis and exit only when your investment thesis has played out, or proved wrong or some new input has been received that vitiates your investment thesis.

The price at which the stock is trading is not really relevant when you decide to exit.

Even if you are a techno-fundamental analyst, then you may still wait and exit at an optimal price (say the stock is bullish, you may trail your stop loss rather than a knee jerk exit).

If your decision was a trading decision based on certain trading assumptions you made, then you will have by the very process arrived at an entry price as well as a price where your assumptions are proved wrong (i.e. stop loss level) and a price where your assumptions are proved right (target levels).

So your decision to enter and exit would be guided by this analysis, irrespective of the fact that you use moving average, or ichimoku or trend line or GANN or some other method to find out entry, stop loss and target levels.

The target level or the stop loss level can be dynamic (say a break of a moving average by more than xx points) or could be pre-defined. 

Know your capital allocation

When you invest money in the stock market, decide how much of the capital you will use for trading and how much for investment.  It is ok if the entire amount is for trading or for portfolio. But you, as the owner of this hard earned money should know exactly what your approach is.

To illustrate, you have 1 crore as your retirement corpus in cash. This is excluding any other fixed or movable assets like home, car, farm house etc.,

Your allocation may be 50% Debt and 50% Equity. Within equity you want to buy and hold (invest) and also churn your money and generate regular income. So you may decide to invest 30 lakhs for buy and hold and 20 lakhs for trading. So your ratio will be 50% debt, 30% portfolio and 20% trading.

Within the 20% you may decide to trade derivatives or cash equity, positional or swing or intraday and so on. Within the 30% portfolio, you may decide to invest in growth stocks or value stocks, in small cap multi-bagger or large cap dividend paying companies.

These are the kind of decisions you will have to take before even you start your investment journey. And if you have not done so, you have to do it sooner rather than later. 

Importance of Price

While I have said so many things price is important. Very important. That entry and exit price determines the money you make. It is something that I have to be aware of. But not something that I have to be obsessed with.

Price is not the master. Your analysis has to be the master. 

Whether you analysis is fundamental or technical or anything else, you have your thesis before investing in a stock. And Price has to follow that thesis. Not the other way round. 

When you are confident about your analysis, then you will not worry about price fluctuations. If you are worried about price fluctuations then you are not confident about your analysis. 

Making money requires homework. And the market rewards those who perform their homework and then come to play. 

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Disclaimer :

This blog is for educational and awareness purpose only. The views are intended for discussion and exchange of views rather than an expert opinion. This is not an recommendation to buy or sell or invest in the stock market and derivatives market. Kindly exercise caution and perform your own due diligence before investing in the market, after fully and clearly understanding the risks involved.