Selecting Rules for Investing and Trading

There are three important differences between investing and trading. Overlooking them can lead to confusion. A beginning trader, for example, may use the terms interchangeably and misapply their rules with mixed and unrepeatable results. Investing and trading become more effective when their differences are clearly recognized. An investor's goal is to take long term ownership of an instrument with a high level of confidence that it will continually increase in value. A trader buys and sells to capitalize on short term relative changes in value with a somewhat lower level of confidence. Goals, time frame and levels of confidence can be used to outline two completely different sets of rules. This will not be an exhaustive discussion of those rules but is intended to highlight some important practical implications of their differences. Long term investing is discussed first followed by short term trading.

My mentor, Dr. Stephen Cooper, defines long term investing as buying and holding an instrument for 5 years or more. The reason for this seemingly narrow definition is that when one invests long term, the idea is to "buy and hold" or "buy and forget". In order to do this, it is necessary to take the emotions of greed and fear out of the equation. Mutual funds are favored because of they are professionally managed and they naturally diversify your investment over dozens or even hundreds of stocks. This does not mean just any mutual fund and it does not mean that one has to stay with the same mutual fund for the entire time. But it does imply that one stays within the investment class.

First, the fund in question should have at least a 5 or 10 year track record of proven annual gains. You should feel confident that the investment is reasonably safe. You are not continually watching the markets to take advantage of or to avoid short term ups and downs. You have a plan.

Second, performance of the instrument in question should be measured in terms of a well defined benchmark. One such benchmark is the S&P 500 Index that is an average of the performance of 500 of the largest and best performing stocks in the US markets. Looking back as far as the 1930's, over any 5 year period the S&P 500 Index has gained in price about 96% of the time. This is quite remarkable. If one widens the window to 10 years, he finds that over any 10 year period the Index has gained in price 100% of the time. The S&P500 Index has gained an average of 10.9% a year for the past 10 years. So the S&P500 Index is the benchmark.

If one just invests in the S&P500 index, he can expect to earn, on average, about 10.9% a year. There are many ways to enter this kind of investment. One way is to buy the trading symbol SPY, which is an Exchange Traded Fund that tracks the S&P500 and trades just like a stock. Or, one can buy a mutual fund that tracks the S&P500, such as the Vanguard S&P 500 Index Fund with a trading symbol VFINX. There are others, as well. Yahoo.com has a mutual fund screener that lists scores of mutual funds having annualized returns in excess of 20% over the past 5 years. However, one should try to find a screener that gives performance for the past 10 years or more, if possible. To put this into perspective, 90% of the 10,000 or so mutual funds that exist do not perform as well as the S&P500 each year.

The fact that 10.9% is average market performance for the past 10 years is all the more remarkable when one considers that the average bank deposit yield is less than 2%, 10 year Treasury yields are about 4.2% and 30 year Treasury yields are only 4.8%. Corporate bond yields approximate those of the S&P500. There is a reason for this disparity, though. Treasuries are considered the safest of all paper investments, being backed by the United States Government. FDIC regulated savings accounts are probably the next safest while stocks and corporate bonds are considered a bit more risky. Savings accounts are possibly the most liquid, followed by stocks and bonds.

To help you calibrate the safety and liquidity question, the long bond holders are comparing bond yields they now receive with next year's anticipated stock yields. Consider that next year's anticipated S&P500 yield is around 4.7% based on the reciprocal of its average price to earnings ratio (P/E) of 21.2. Yet the 10 year annualized return of the index has been 10.9%. Bond holders are prepared to accept half the historical yield of stocks for added safety and stability. In any given year, stocks may go either up or down. Bond yields are not expected to fluctuate widely from one year to the next, although they have been know to do so. It is as if bond holders want to be free to invest short term, as well as, long term. Many bond holders are thereby traders and not investors and accept a lower yield for this flexibility. But if one has decided once and for all that an investment is for the long term, high yield stock mutual funds or the S&P500 Index, itself, seem the best way to go. Using the simple compound interest formula, $10,000 invested in the S&P500 index at 10.9% a year becomes $132,827.70 after25 years. At 21%, the amount after 25 years is more than $1 million. If in addition to averaging 21%, one adds just $100 a month, the total amount after 25 years exceeds $1.8 million. Dr. C. rightly believes that 90% of one's capital should be allocated over a several such investments.

Now that you've allocated 90% of your funds to long term investing, that leaves you about 10% for trading. Short to intermediate term trading is an area that most of us are more familiar with, probably due to its popularity. Yet it is significantly more complex and only about 12% of traders are successful. The time frame for trading is less than 5 years and is more typically from a couple of minutes to a couple of years. The typical probability of being right on the direction of a trade approaches an average high of about 70% when an appropriate trading system is used to less than about 30% without a trading system.

Even at the low end of the spectrum, you can avoid getting wiped out by managing the size of your trades to less than about 4% of your trading portfolio and limiting each loss to no more than 25% of any given trade while letting your winners run until they decrease by no more than 25% from their peak. These percentages can be increased after there is evidence that the probability of choosing the correct direction of a trade has improved.

Intermediate term trading is based more on fundamental analysis which attempts to assign a value to a company's stock based on its history of earnings, assets, cash flow, sales and any number of objective measures in relation to its current stock price. It may also include projections of future earnings based on news of business agreements and changing market conditions. Some refer to this as value investing. In any case, the objective is to buy a company's stock at bargain prices and wait for the market to realize its value and bid up the price before selling. When the stock is fairly priced, the instrument is sold unless one sees continuing growth in the value of the stock, in which case he moves it over into the investment category.

Since trading depends on the changing perceived value of a stock, your trading time frame should be chosen based on how well you are able detach yourself from the emotions of greed and fear. The better one can remove emotions from trading, the shorter the time frame he can successfully trade. On the other hand, when you feel surges of emotion before, during or immediately after a trade, it's time to step back and consider choosing your trades more carefully and trading less frequently. One's ability to remove emotions from trading takes a great deal of practice.

This is not just a moral statement. An entire universe of what's called technical analysis is based on the aggregate emotional behavior of traders and forms the basis of short term trading. Technical analysis is a study of price and volume patterns of a stock over time. Pure technicians, as they are called, claim that all pertinent news and valuations are imbedded into a stock's technical behavior. A long list of technical indicators has evolved to describe the emotional behavior of the stock market. Most technical indicators are based on moving averages over a predefined time period. Indicator time periods should be adjusted to fit the trading time frame. The subject is far too large to do it justice in less than several volumes of print. The lower level of confidence involved in trading is the reason for the large number of indicators used.

While long term investors may use only a single long term moving average with confidence to track steadily increasing value, traders use multiple indicators to deal with shorter time frames of oscillating value and higher risk. To improve your results and make them more repeatable, consider your expectations of changing value, your time frame and your level of confidence in predicting the outcome. Then you will know which set of rules to apply.

James Andrews publishes the Wiser Trader Stocks and Options Newsletter. Information on selected stock market trading systems, including those of Dr Stephen Cooper, can be found at http://www.wisertrader.com.

© 2004 Permission is granted to reproduce this article, as long as, this paragraph is included intact.

Invest or be Pink Slipped

Firing an employee seems to be easier and easier for corporations. Up until now you... Read More

Issuing Warrants to Investors

When raising capital for a business venture, warrants are a common form of equity that... Read More

Invisible Mutual Fund Fees Erode Your Returns!

Many investors think that investing in mutual funds is free. What nonsense! Funds collect more... Read More

Chinas Great Missed Opportunity

While a U.S. Representative to the Asian Development Bank Executive Board of Directors during the... Read More

Selecting Rules for Investing and Trading

There are three important differences between investing and trading. Overlooking them can lead to confusion.... Read More

Retirement ? Its Sooner Than You Think!! (Honestly)

Many people hear "retirement" and think- what? 401K? Roth vs. Traditional IRA? Stocks, bonds, mutual... Read More

HYIPs Investments or Scams?

High Yield Investment Programs (HYIPs) appear at first to be the secret to unlimited wealth... Read More

Remembering TEOTWAWKI and Learning from It

Its only been about 5 years since we had major scares in the marketplace regarding... Read More

Making It Second Nature

Not long ago I was laying on my son's floor throwing one of his toy... Read More

The Benefits of Laddering Your CD Investments

If you've decided to stock some money away in a certificate of deposit, why not... Read More

Learn How to Lose and Risk Management

One of the leading traders on Chicago Mercantile Exchange, because of a single trade lost... Read More

Investors: Avoid These 5 Common Tax Mistakes

For many investors, and even some tax professionals, sorting through the complex IRS rules on... Read More

Keeping It Interesting

Some lines from a movie never leave your mind; I don't remember the context always,... Read More

Real Estate Clubs Hot Among Investors

Six or seven years ago, the stock market was booming, Internet companies that no one... Read More

A Safe Port For Mutual Funds But Not You!

Soft dollars, a form of legal kickback, is a sly way you can get ripped... Read More

Four Key Components To Building A Trading System

Need some insight on what you should really be striving for when you're building a... Read More

Have You Ever Seen A Map of the World Turned Upside Down?

For those accustomed to viewing things a certain way, it is quite disconcerting. One almost... Read More

Day Trading Strategy or Stock Trading Software? The Way You Pick Stocks Affects Your Results

The trading method you employ to approach the stock market can make a big difference... Read More

Rolling your 401k: Contributory IRA vs. Rollover IRA

In an ideal world you would start your working career with a great company in... Read More

Overbought/Oversold

Has your broker ever told you that a stock is "overbought" or "oversold"? He probably... Read More

Stock Market Horizons: Gold $3,000, Oil $70

In the last two decades, even though gold prices have dwindled from $850 to $350... Read More

Variable Annuities

You know all the articles you read about annuities that have extremely high fees? And... Read More

Investing In or Owning Drug Lab Properties

Clean Up (includes the insides and the outside of a building)Air out the buildingRemoval of... Read More

Ask The SEC

Who is the SEC and why should I ask them anything? The Securities and Exchange... Read More

Numismatics are for Collectors, Not Investors

As a precious metals investor, you may heard much about numismatic and "semi-numismatic" coins, particularly... Read More

Wit and Wisdom on Money, Wall Street and Success - Part #1

I love to collect quotes as they concisely promote a philosophy which is readily understandable.In... Read More

Investing and the Fear of Regret and Greed

People tend to feel sorrow and grief after having made an error in judgement.Investors deciding... Read More

The American Age of Inflation is Over

"The American Age of Inflation is finished." So says economist Robert Samuelson in his December... Read More

The 8 Biggest Mistakes When Designing Portfolios - and How To Avoid Them

Are you as good an investor as you think? Do you consider yourself a well-informed... Read More

Need To Trade!

You don't HAVE to be trading.As a novice trader, you'll often feel the need to... Read More

Gold and Silver Maple Leafs Get New Packaging

Gold Maple Leafs and Silver Maple Leafs are receiving packaging makeovers, changes clearly mandated by... Read More

Investing & Online Stock & Share Trading: Money & Risk Management - Atkinson Portfolio Planner (1)

This article was originally featured in Daryl Guppy's 'Tutorials in Applied Technical Analysis', voted no... Read More

Seecrets on Investment: Tired of Making Huge Losses in the Stock Market ? Part 1

Over 80% of all individual investors lose money in any given span of ten years.... Read More

An Old Dividend Stock Investment Idea, for a New Generation

Death and taxes! The certainties of life! And then, of course, there are the mortgage... Read More

Asset Allocation: Critical to Your Investment Success

Asset allocation is a critical component of investing success. Both research and academic studies show... Read More

Gold; What Type of Gold to Buy

JewelryThe advantages are:? Gold Jewelry is the easiest of the gold to buy and has... Read More

Investor Guide to Financial Health

Step 1: Spend less than you earnPerhaps the simplest financial concept is the toughest for... Read More

Asset Allocation Lessons: The 70% Inflation Solution

For investors only... and for speculators who need to invest their winnings.Lesson One: Asset Allocation... Read More

Getting Started In Investing

Are you ready to open your pathway to financial independence?Well you should be. The sooner... Read More

Time is Money and We Are Running Out of Both!

One of the fundamental principles of finance is the concept that $1 today is more... Read More

Risk and Reward

If you are doing your own investing in the stock market, what would be the... Read More

Foreign Investing - US Investors Still Missing Out?

Investors are still too slowly realizing what the academics have long pointed out ?- adding... Read More

Pros & Cons of Investing in Bonds

What are Bonds?A bond is a debt security, by which you are lending money to... Read More

Protecting the Tax Advantage of Your Deferred Compensation

The American Jobs Creation Act of 2004 imposed strict new rules on non-qualified deferred compensation... Read More

Trading Systems

A trading system consists of a set of rules for viewing markets and making trades.... Read More

Eight Questions to Ask Your Financial Advisor

You may like your financial advisor, but is he really looking out for you? All... Read More

Diversify!

The best way to avoid being hit hard by a stock market crash or another... Read More

Help with My Annuity

The cries are heard from the distance, "I need help with my annuities." Nothing has... Read More

Is a SEP Plan Right For Your Business

A SEP is a special type of IRA. Under a SEP plan the employer creates... Read More

Buy: Hold: Sell: Jump

I'm sitting here at my computer desk with a cup of coffee at my elbow.... Read More