People tend to look at trading and investing as two different pursuits, the first being more risky and shorter-term than the second. However, if you really think about it, they are simply two approaches to solve the same problem – How to buy low and sell high. If both approaches have their merits, it would make sense for investors to incorporate helpful trading concepts into their investing.
Think of Risk Reward
Consider this example: Your friend comes to you with a business idea that could make a maximum of $1000 a year, but requires $50,000 in upfront capital-at-risk. Would you still invest?
This is the number one area that conventional investing usually leaves out. While focusing on company fundamentals, long-term value investing hardly specifies the risk involved in buying a stock. Without quantifying a stop loss point, in theory you could lose your entire investment down to 0. This is a huge issue for those who invest a huge portion of their life savings.
Stock research reports further display this mindset, by only showing a Target Price, but no Stop Loss (because who wants to read something that says they may lose money?). Through simple measures like maximum percentage loss, or the breaking of technical support levels, one could know in advance when to get out if the investment does not go as planned. Additionally, by comparing it to where one thinks the price can potentially reach (potential reward), one would have an idea of the risk-to-reward ratio they are taking.
Only Price Pays
There is a common adage in trading that “Only price pays”. Everyone knows this, yet there are many who don’t apply it. What do we mean?
In university finance courses, one would learn about price-to-earnings, price-to-book ratio, and other ratios that signal under or overvaluation. On top of that, the mainstream finance industry encourages looking at financial statements, and so on. While these measures are helpful to determine value, it becomes an issue if one only focuses on that.
The determinants of a stock price (especially across shorter time horizons) are far more complex than its financial statements or valuation ratios, and could include a multitude of other factors like insider interest, trading algorithms, sector sentiment, macroeconomic changes, and so on.
Since the price alone determines your profit or loss, wouldn’t it be wiser to place your primary focus on that instead?
Market Can Stay Irrational Longer Than You Can Stay Solvent
Building on the previous point – this is perhaps the most dangerous part about stock investments, and is the reason for major account blowups.
Say you have done months of research on one stock, and are very bullish on it – this is what people call “conviction”, and bears some similarity to a common psychological bias known as “confirmation bias”.
This means that when you invest in a stock, you are also emotionally invested since your ego comes into play (whether you are right or wrong). Even though the price may have gone way below your entry price, you will not cut the loss. Either through blind hope or biased reasoning (“My analysis is definitely correct, the price will come back”), your mind works to protect your sense of confidence and stops you from admitting you are wrong.
Even if your fundamental view is correct, markets can go against you for much longer than you expect, and your losses may balloon to an amount that your risk appetite cannot stomach. Learning to accept this fact, and allowing yourself to exit a small loss when you’re wrong, would protect your portfolio from catastrophic losses.