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Tuesday, May 8, 2007

Master and Novice - Investor, Trader, Speculator ...

In the context of stock investing in Bursa, we frequently hear terms like "investor", "trader", "speculator" and even "gambler". Expand a little, and we might hear terms like "value investor", "growth investor", "momentum investor", "business analyst", "market analyst", "fundamental investor", "technical investor", "actuary investor", "intelligent investor", etc. I am sure some of you will even hear terms like "stock operator" (it sounds old-fashion, like a telephone operator - vague but neutral). And most likely we all have our own understanding of what these various terms mean.

I believe there is no one single right understanding of these terms. But sometimes, it's good to reflect on the differences, only to better understand the different methods used in search of better investment returns. It is also important to understand that with each method, there are "masters" and there are "novices". You'll know who the masters are only when they consistently generate above average returns over the long term. (I would regard someone like Buffett as a "grandmaster").

And naturally, because there is no one "master reference" that is agreed and accepted by everyone, most people tend to call themselves "investors" or "traders" (even when some of them might actually be just gambling).

I thought it might be worthwhile to set out my own understanding on these terms. Why? Well, mainly to clarify my own thought, but also to stimulate discussions on similarities and differences, who might be the master in each category, and perhaps better understand ourselves in the process. You might have heard of another term which I might not have mentioned here or simply have forgotten - if so, please feel free to comment. As this is my own understanding, I understand that it might be different to yours.

So, here's my own understanding so far.

1. Investor
- an investor might invest in the same way as a typical parent might "invest" in their child's education - spend some money today (say, to send their child to overseas universities to acquire better skills/knowledge/experience), in the hope that in future, the child would be able to secure a higher paying job and earn more than the cost of the original investment.
- there is the belief that the future will bring better things, and patience is generally a virtue.
- the selection criteria tend to be based more on the underlying business fundamentals, rather than the stock price & volume technicals.
- believes that in the short run, the stock market might be a voting machine (supply and demand), but in the long run, the market invariably is a weighing machine (earnings).
- an example of a Master Investor = Buffett.
- an example of a novice investor might be someone who invest based on say just one fundamental ratio (e.g. P/NTA< 1) indiscrimately. The difference between him and Buffett is probably in the level of understanding of the business behind the counter (e.g. economics, valuation, earnings, future prospects, management, etc), the differences in intrinsic value and margin of safety assessment. He might blindly follow Buffett's idea of concentration, but instead of getting superior returns, he might get an opposite or inconsistent result over time.

2. Trader
- the basic idea is to sell at a higher price than the original buy price.
- operates a bit like a commodity trader or a retail shop. Doesn't really care which stock or what type of product, so long as they are confident that they can sell at a higher price than they bought. Especially during speculative bubbles when the game becomes focussed on finding the greater fool (buy very high, sell even higher).
- there are many different types of traders, but probably most would use technical analysis (based on historical prices and volume) .
- an example of a Master Trader = Jesse Livermore or Charles Darvas.
- an example of a novice trader might be someone who buys a stock because today's price is higher than yesterday, without regard to other technical considerations. The novice would differ from the Master in many ways - e.g. the novice might have applied an incorrect "reading of the tape" (or candlesticks charts, technical indicators, etc.), the novice might not have set or execute the stop loss correctly (to keep losses small and letting the winners ride), the novice might not stick long enough to his trading plan for the laws of average to work, the novice might have over/under-traded (e.g. bet large when odds are merely 51/49, bet small when odds are 80/20), etc.

3. Speculator
- A speculator (or someone who "speculates") frequently have a hypothesis (or a set of hypothesis) about what's going to drive the price up / down, and that hypothesis frequently determines the buying/selling decision.
- For example, they might think that CPO prices will go up due to some fundamental reasons, and when they do, it will drive future earnings of CPO stocks up and so, they buy CPO stocks now. Nothing wrong right?
- An example of a Master Speculator would be Soros (cf. famous for his large Sterling bet in 1992 that broke the Bank of England).
- An example of novice speculator? Well, there are probably too many in Bursa Malaysia, with below average results. There are many differences, but the average speculator might not realize that George Soros don't take risks. Yes - you've heard me right. Even when Soros took on a highly leveraged position of $10B, backed by an entire fund size of $7B against the Sterling (this is definitely not Graham style of diversification), he has already done his calculations and has set his plans already such that in the worst case scenario, he would lose only 4% ... Yes, only 4% of his capital ... Interesting isn't it? You can see that this is in stark contrast to the average speculator, some of whom might even consider betting their house and car and if it didn't turn out as expected, they then lose their house and car ... Naturally, there are many other differences between Soros and the average speculator besides limiting risks and give due consideration to both upside and downside. Some differences that comes into mind are superior understanding and superior quality of hypothesis, always testing the hypothesis against the facts as they evolve for confirmation or otherwise, extreme flexibility (not having a fixed mind or a fixed position, definitely not stubborn), willingness to quickly admit mistakes and cut loss, position sizing, margin of safety, objectivity, etc. Generally, a master of his craft.

4. Gambler
- I suppose there are many "investors" out there in Bursa who would buy a stock based on a stock tip, without knowing either the fundamentals nor the technicals of the stock (nor the tip adviser). To me, that would seem like gambling.
- Novice gamblers might differ from Master gamblers in the source and reliability of their tips. E.g. a novice gambler might have heard from his neighbour that so-and-so a stock will go up through the roof, without checking whether the neighbour (or his source) has a good and successful long-term track record, and whether he/she is reliable or trustworthy. A Master gambler might be someone with close personal & business connections on the inside, and have checked and make sure that the source is completely trustworthy and reliable before considering any actions. The Master might even apply other methods to supplement his decision, to increase his margin of safety (e.g. have other independent and highly trusted source to verify, have personal copies of certain key or sensitive earnings information not yet released, etc.). Of course, insider trading is illegal, so, we won't point fingers at anybody right?

5. Value vs Growth investor
- A value investor might be looking for an investment where he can buy $1 worth of business for $0.50, and a growth investor might be looking for an investment where he can buy $1 worth of business today for $1 because he believes that the $1 today will grow to $2 in future.
- In other words, both value and growth investors could still be fundamental investors. They are not pure technicians, since both investors assess intrinsic values. My own belief resonates with Buffett, who believes that there is really no distinction between the two - in my experience one can sometimes find both value and growth in Bursa, i.e. it's possible to buy $2 worth of business in future selling for less than $1 today :-). Also, a business that is almost certain to be worth $2 tomorrow and selling at $1 today is good value isn't it (even if the accountants calculate its NTA to be $1 on the last balance sheet date)?

6. Momentum investor
- The momentum part typically refers to price momentum, i.e. suggestive of a technician rather than a fundamental investor.
- Jesse Livermore is an example of a Master momentum investor since he discourages trying to buy at the absolute bottom, and selling at the absolute top. Some of his most famous quotes are "the trend is your friend", "the lowest eights and highest eights are the most expensive eights", etc.

7. Business Analyst
- Buffett is clearly the master here, with an excellent understanding of the underlying business behind the stock ticker.
- The business analysts typically takes a "bottom up" approach to investing (i.e. start from the individual company first, and then work yourself up to the industry, country, global economy), although strictly speaking a "top-down" approach could generate specific company ideas that would enable a more efficient "bottom up" analysis. To a master Business Analyst, I believe all these would probably happen on the subconscious level, without conscious awareness. Contrast the novice who might spend a lot of time debating with himself whether to adopt a "top-down" or "bottom-up" approach, instead of actually analyzing a specific company and forming his own business conclusions.

8. Market analyst
- The difference between Business analyst and a Market analyst is that a Market analyst focuses on the Market. The definition of the market might be either the stock market itself, or the market/industry in which the company operates in (e.g. instead of focussing on MASTEEL say, the market analyst focuses on the steel market in general).
- Buffett himself doesn't think too highly of market analysts and I believe he meant that it's better to be a good business analyst first, since a good business analyst needs to know something about the competitor and the market in general (e.g. steel market), but a good market analysts might not need to know anything about the valuation of a specific company (e.g. MASTEEL debts).

9. Actuarial investor
- Mark Tier, in his book "The Winning Investment habits of Warren Buffett & George Soros" has a good definition of the Actuary on page 126.
- "Actuary deals in numbers and probabilities. Like an insurance company, he is focused on the overall outcome, totally unconcerned with any single event."
- To me, one of the earliest Master Actuary investor would be Graham. He would hold hundreds of stocks that meets his criteria (e.g. low P/E, low P/NTA, etc.). He frequently doesn't know which stock will rise. He also doesn't know which stock will fall and go bankrupt. But he knows that as a group, provided he bought all such stocks at a low enough price, a few might go bankrupt, a few might not move, and the rest will move up in such a way that overall, he is almost certain to make a profit on his entire account, a profit that could beat or match the market index. The idea is similar to insurance companies writing life insurance for a pool of diversified lives (spread across the entire country is better than concentrated in a single building). Insurance companies don't know who exactly is going to die next, but they will know, with quite a high degree of certainty, how many lives in the pool of insured lives are expected to die in a year, based on statistical investigations conducted by the Actuary. Hence the phrase "Actuarial investor" (or "The Actuary").

10. Fundamental vs technical investor
- Hopefully, self explanatory by now ...

11. Intelligent investor
- This doesn't necessarily refer to IQ or intelligence.
- Graham's famous summary quote (on Chapter 20, page 523 in his Intelligent Investor book) says it best: "Investment is most intelligent when it is most businesslike".
- There are many levels of understanding to the bold phrase.
- At one level is to imagine as if you are running a trading shop. What would you do to be financially successful? A successful operator would ensure that in the long run, the cost of buying all his goods is at a lower price than what he could sell to ensure a profit (after tax, expenses and other costs) that is not just positive, but is also higher than what he could obtain by merely investing his capital passively. So must an intelligent stock operator do the same thing. Only sell shares at a high enough price to make sure that it covers original buy cost, expenses and tax, so that at the end of the day, it provides a high enough profit on the total account that is higher than what he could obtain from a passively investing in either Fixed Deposits or a broadly representative Mutual Fund. Of course, the difficulty with stocks is that its buy and sell price are not predetermined in advance, and can fluctuates daily.
- Another level of understanding is to buy a stock like as if one approaches the task of buying a business. This is fundamental investing. If you buy a business from the private market, you would naturally evaluate the business economics carefully, assess its assets and liabilities carefully, study its past and evaluate its future earnings prospects carefully, its management, staff, competitors, the degree of economic moat, etc. Similarly, when you sell a stock, in the same manner as to whether you would sell your own private business to a 3rd party.

12. A stock operator
- From "Reminiscence of a Stock Operator", a biography on Jesse Livermore. A fairly neutral term, although perhaps old fashion, vague, and can make one wonder what exactly does an operator do. (cf. telephone operator?). In the book, the author was obviously referring to the process of buying and selling stocks.

Some concluding comments
- There is clearly more than one method and path to riches in the stock market, just as there are many different ways to become poor in the stock market.
- I believe for most people, it is practically more important to understand the differences between a Master vs a Novice in their chosen investment methods (including understanding where they've gone wrong and what they could do better), than debating various terminologies and minor differences in understanding.
- Nevertheless, different methods do exist, and I believe it is important to understand what investment style or method one is currently using, to make sure that it fits within one's broader and unique personality. For example, someone who can't sit still patiently and needs everyday action would do better as a trader than a value investor, although this of course can only be a generalization.
- For someone beginning to invest, I believe that it is more important to learn and thoroughly understand one method first, and to master that, before one can make money consistently and even before considering other methods.
- I also have a suspicion, that different methods might work better at different stages of the market. For example, in a bear market, value investors who are able to pick good value stocks will tend to do better, whereas in a long boom market that last years, value investors might tend to sell off their holdings too soon (especially when it's above any reasonable measure of intrinsic value), whereas momentum players who don't see a weakness yet tend to be more successful to ride the long upside and churn out a better performance.
- Having said that, one clearly does not need to master more than one method to accumulate huge wealth - Buffett is the clearest example of someone who has created an amazing amount of wealth by using largely one (i.e. his) method of investing.
- Personally, I find myself continually learning new skills and find my investment style evolving from a value investor to what I called a "fusion investor" (so now you know why I called this blog "Fusion Investor"), someone who applies more than a single technique to investing. Currently, I'm probably still 80% value, although I suspect this % might change in future. Also, I sense that Bursa Malaysia has its own set of characteristics that is quite different from say, the NYSE. I "feel" Bursa might be more news based than fundamental based (e.g. certain stocks tend to rise much more upon announcement of certain news, than what a prudent and rational business analysis would indicate, especially if the transactions are conducted in the private market). It also seems like it's more speculative based (just witness the huge proportion of retailers and syndicates playing the active stocks). But these are just my own impression, and naturally, can be biased.

As usual, the above are just merely my views. Use your own judgement and invest at your own risks.


Ben Gan said...

Please accept my appreciation for putting together a master piece of writing.
I fully agree with you that different tactics should be applied at different stages of the market.
Value investing, growth investing & momentum investing combined can really produce excellent results.
Cheers and happy investing.
Regards, Ben

Seng said...

Hi Ben,

You're welcome. It was a pleasure to write, as I had no deadlines and just took my own sweet time :-) Various excellent blogs like yours, Blisswind, Fusion Trader, notwithstanding numerous good investment websites, books, past discussions, etc. planted the seed and provided the topic for this write-up.

Thanks for your kind comments, and Happy Investing to you too.