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.

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