In my 15 years in the financial industry this simple question is the most basic, and yet one of the most misunderstood.
Let’s start by defining what I mean by the terms “trader” and “investor”. To borrow from one of my favorite bloggers, Carl Richards, “Trading is the buying and selling of individual stocks over short periods of time. Investing, on the other hand, is the purchase of diversified investments and requires holding them for long periods of time.” I think many of us often confuse these two completely different activities.
Most of us would probably classify ourselves as investors by these definitions. Yet when we think of investing, we are more likely to think like traders. Why? Consider what you see and hear from the media. The financial media, both print and electronic, is full of headlines that are designed to catch your eye. Article titles like, The Top 10 Stocks You Should Own Now or Five Things You Need to Know Now, appear often. These kinds of lists make headlines because they talk about ideas that appear to be actionable. And don’t we all want to do the best we can with our investments? It’s not limited to the financial media either. When your best friend tells you about a stock or mutual fund he bought that’s “sure” to take off, doesn’t your brain tell you that you should do something? However, this type of reactionary thinking probably won’t lead to sound decision making.
If you see yourself as an investor: What can you do to be a better one? How can you fight the urge to act like a trader whenever the market is volatile?
The 2014 Dalbar study1 has suggested that one big mistake investors make is getting in and out of the market at the wrong time. A March 2014 Barron’s article, Investor Returns Lag Fund Performance, suggests a different sort of bad behavior that is impacting investor returns. According to the author, “The problem is that investors tend to get in and out of an asset class [italics added] at the wrong time.” If the Dalbar and Morningstar reports are correct, that the average investor significantly underperforms the average return of the overall market, what can you do to protect yourself from bad behavior?
Don’t think like a trader.
Thinking like a trader can cause us to make rash decisions. For example, let’s say you look at your 401(k) statement and see that, of your nine funds, three are losing money while three other funds are up significantly. Do you feel compelled to take the money from the underperforming funds and move it into the funds that are doing well? Unfortunately, this is often done without thought to overall asset allocation and other potentially significant considerations. This short-term thinking can cause you to buy into funds that are at the top of their cycle and sell out of funds at the bottom. Does buying high and selling low sound like a strategy you should employ? Maybe you are not getting into and out of the market at all but are you making moves within market segments at the wrong time? What other bad behaviors might you be guilty of?