Sunday, April 15, 2012

Trading vs Investing

Let's get something straight...most people who think they are investing, are actually traders.  What's the difference?


Back when I was a stockbroker working for Fidelity Investments I was a part of a 10 person team.  For whatever reason our "theme" was pirates.  It was very unusual to say the least.   I worked with some interesting characters and they helped make it fun.  I also appreciated the teamwork and training that Fidelity provided.  Something that always bothered me was the word trader.  Every time I heard the word I thought of traitor. 


Many people today invest in a mutual fund.  A mutual fund is a basket of stocks that were purchased by the mutual fund manager.  Typically these fund managers buy and sell stocks periodically throughout the year.  If you have ever read a fund prospectus...it will tell you the portfolio turnover percentage.  An example prospectus to look at is the Dodge & Cox Stock Fund (disclosure - I do not own this fund).  If you type in the search box the word "turnover" it will take you to the company's rate which is 12%.  Here is an example.


Let's say I'm a mutual fund manager and I am going to buy the following stocks.  This is an example, and I will pick stocks that should be recognized by most people.


Included in this portfolio are the following 10 stocks (inside parentheses is the stock symbol):


Year 1
Coca-Cola (KO)
Pepsi (PEP)
Home Depot (HD)
McDonalds (MCD)
Bank of America (BAC)
Apple (AAPL)
Microsoft (MSFT)
Time Warner Inc. (TWX)
AT&T (T)
Exxon Mobil Corp (XOM)


If my turnover rate is 10%...this means I'm going to sell one of these companies each year, and purchase another company. 


Year 2
Coca-Cola (KO)
Pepsi (PEP)
Home Depot (HD)
McDonalds (MCD)
Bank of America (BAC)
Apple (AAPL)
Microsoft (MSFT)
Time Warner Inc. (TWX)
AT&T (T)
Wells Fargo (WFC)


I decided that I would sell Exxon Mobil, and purchase Wells Fargo.  As a mutual fund shareholder, you probably didn't even know this took place.  Why?  Because most people do not read the prospectus or annual reports.  After all, you trust the mutual fund.  But why?  I wish I knew the answer.


So, after 10 years as a fund manager I would have replaced each company with another, or purchased back a company shares that I previously sold.  This my friends is trading stocks.  Buying low, and selling high.  This is an example, and isn't quite exactly how this works, but it gives you an idea.


I would argue that most mutual funds are traders not investors.  Even though the old adage is "Invest for the long term!" Actually, I'd say that most mutual funds are traitors because they act like they are on your side, but then take a large part of the money...kinda like modern day pirates.


Folks many mutual funds are trading stocks with your money.  Sometimes you might even see a turnover rate of over 100% in a year.  This means the fund manager sold everything and bought/sold some more stocks.  This can happen when a new fund manager is in charge of the fund and didn't like the stocks in the portfolio, or wanted to change the fund's goals.  This costs the mutual fund shareholders a lot of money.  You know what else costs mutual fund shareholders money?  Anytime a large client bails on the mutual fund.  This forces the mutual fund to sell company shares to pay the customer his/her money.  The other shareholders suffers because of this, and could force the fund to incur capital gains (meaning you get taxed).  Or what the fund will do is sell some winners and losers to avoid such large tax consequences and everything evens out.


Can you make money trading?  Sure you can!  Some mutual fund managers are better at trading than others.  Can you do better than them?  Maybe...


If you like the idea of being a trader, you could buy low and sell high many items besides stocks.  Many times without paying commissions.  I have a friend who is a doctor that has bought paintball markers off Craigslist, used them, cleaned them, and then sold them for more money.  How?  Well, he knows the value of the equipment.  If the price offered is lower than the value, then he will purchase the equipment.  It can be a quick way to make money, but I wouldn't call it investing.


People who buy houses many times plan on moving in 5-7 years or they want to upgrade to a bigger house by then.  This isn't investing in a home, this is your attempt at trading.  Buying low, and selling high.  What is an investment in a home?  Rental property could be an investment, or even Warren Buffett's investment in his house that he bought back in 1957 and still lives in today.  Flipping houses?  That is the job of a trader.  As we all have learned, that traders can lose everything pretty quickly.  I'd go so far to say it ranks in the category as a get rich quick scheme for most people. 


An example of investing would be taking the time to learn the skills needed to be a great trader.  Those skills will last a lifetime.  That is a real investment!  Instead of money, you invest your time.  Education can also be a huge liability.  I will talk more about this topic in a future article.


If you have mutual funds...I suggest you read the prospectus.  Look at the turnover percentage, mutual fund expenses, and performance.  You might be surprised at what you read.

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