Karthik, a good friend, forwarded an article from ColloborativeFund.com titled “The Reasonable Formation of Unreasonable Things”.
The article talks about how market bubbles and crashes are inevitable. And that bubbles are a result of shortening investment horizons. And that volatility is needed if you need big returns. The article made a lot of sense to me. By the way, the article talks about many other aspects too.
You can read the article here. In my opinion, it is a must-read.
In my post, I can’t touch upon the breadth of aspects covered by the author of the aforementioned article. I will delve upon the role of traders and investors in the markets and how their expectations are way different, which may lead to very different actions.
I must concede all the ideas have been borrowed from the aforementioned article (or my understanding of the article). You must go through the article from Collaborative Fund.
Trader and Investor
A Trader relies on technical chart patterns (price-volume charts) to make a decision. The investment horizon is short, perhaps hours, days, weeks or a few months.
An Investor relies on fundamental analysis i.e. company performance, industry prospects, the level of competition, valuation levels to make decisions. Investment horizon is relatively long, can stretch on for many years or decades.
By the way, there is another class of participants who do no homework and simply act on hot tips or watch CNBC 4 hours a day to select their picks or do whatever their doctor, CA, dentist or colleague is doing. I call them Speculators. These conveniently switch from being a trader to an investor or vice-versa. Trader for winning picks and Investor for losing picks.
Though it is unfair to smart traders, I will club these speculators with traders since these are really looking for short term gains. By the way, smart traders should be thankful to speculators for traders make money at their expense.
How does a Trader think?
For a trader, it does not really matter if the Infosys is trading at Rs 1,000 or Rs 10,000.
All the matter is if the chart patterns (price and volume) are bullish.
A smart trader simply tries to follow the trend, get Risk-reward in his favour and size his position correctly. He knows a few trends will go wrong. All he needs to ensure is that he is not knocked out and that lives to see another day (has enough capital left).
To be a successful trader, the importance of getting risk-reward right can never be highlighted enough.
If he purchases the stock at Rs 1,000, he will have a target of say, Rs 1,050 and stop loss of Rs 975. Potential Reward of Rs 50 and potential loss of Rs 25.
If he purchases the stock at Rs 10,000, he will have a target of say, Rs 10,500 and stop loss of Rs 9,750. Potential Reward of Rs 500 and potential loss of Rs 250.
In both cases, the risk-reward ratio is 2:1.
Even if the trader purchased at Rs 10,000 he does not care if the stock is at Rs 5,000 after a year. Why?
Because he would have exited at Rs 9,750. He wouldn’t be counting losses when the stock hits 5,000. He exited much earlier.
By the way, I am talking about smart traders and not about those traders who would rather take their losing stocks to their graves.
The irony is that many of us are traders for your winning picks and investors for losing picks.
Therefore, a smart trader does not care if the stock PE multiple was 2, 20 or 200 when he purchased the stock. He doesn’t need to. For him, trend is the friend.
For all you know, in the case of trend reversal, he may take a short position in cash or derivatives market and make money even on the downside. There is no emotional attachment with the decision or the stock.
For a trader, it makes sense to purchase the stock even at Rs 10,000 so long as the trend is bullish and risk-reward is in his favour.
As an investor, can you afford that?
No. Because your investment horizon is way different.
Traders may be purchasing a security for minutes, hours, days or weeks.
However, as an investor, you may be purchasing a security for many years.
But the market is the same. Both of you are playing the same game.
Therefore, you can’t make your decision looking at what others (traders) are doing. This is because they are doing this for a very different reason.
If you feel miffed at the rising market levels and can’t understand how others can see value in the market, now you know the reason.
A trader does not mind purchasing a stock at high valuations. All he cares about is trend and momentum. If there is a reversal in price-volume trend or momentum, he will cut losses and exit.
This was decided before he entered the trade.
However, for an investor, stock going from Rs 10,000 to Rs 5,000 will mean a loss of half the capital.
If the stock is Rs 5,000 after 10 years, it matters to you if you purchased the stock at Rs 1,000 or Rs 10,000. In the first case, your investment has gone up 5 times, while in the second case, you are down 50%.
Therefore, expectations and investment horizon of other participants may be way different from yours.
Acknowledge this reality.
By the way, this is true not just for equity markets. It is true for all capital markets. While you may scoff at low rental yields in real estate markets and may feel such high real estate prices can’t sustain, but there are other dynamics at play.
A short term trader does not mind high real estate prices so long he feels that he can dump it onto others at an even higher price after a few months/years. Essentially betting on liquidity and price momentum to sustain.
A perfectly rational approach for a short term player.
As markets give good short term returns, the market attracts more traders (with ever shortening investment horizons) and traders become the dominant force in the markets.
Both Traders and Investors are important to markets
If there were only investors and all of them thought alike, no transactions will happen.
For every trade/transaction, there has a buyer and seller.
If you want to purchase a stock because it is over-valued, there has to be somebody who thinks the same stock is under-valued. Why else would he sell?
Therefore, the counterparty to your purchase transaction will be an either:
- An investor whose expectations are way different from yours; or
- A trader who does not care about valuations and is playing a different game.
You need both for capital markets to thrive.
For any thriving market, you need liquidity. For liquidity, you need market participants (traders, investors, speculators). For them to participate, they need to see gains or potential for gains.
For gainers to make money, somebody needs to lose money (at least in derivatives market). Losers need hope. And markets provide ample hope because markets are volatile. Markets are volatile because there are many participants (liquidity) with different expectations and investment horizon.
This completes the cycle.
What I am not saying?
- That the markets are over-valued at the moment and that you should stay away,
- That the markets are undervalued at the moment and that you should invest heavily.
- That you should rely on PE multiple to take a call on market valuation. Firstly, because you need to dig much deeper to understand the correct level of earnings.
- Secondly, these ratios can change quickly. Suppose a stock has PE of 50. However, if the earning double over the next year and the price stays the same, the PE ratio will be a comfortable (perhaps) 25. I will not get into what you should do. You may have to refer to other resources to form an opinion on this matter.