Are you an investor in stocks or a speculator in the company? This question may seem confusing, but it is an important distinction. If you don’t know the answer, it will be difficult to make wise decisions when buying and selling stocks.
Speculation in Stocks
When you speculate in stocks, you are only hoping to profit. You buy because you feel there is a movement in prices for some reason (through technical analysis, market/sector news, etc.).
Since you are only interested in profiting from price movements, you are likely to sell and move on to another stock. You may hold the stock for a short or long period – it depends on price movements and your plan. You have no real interest in the company that issued the stock other than that it is in the right place at the right time.
Investing in the Company
When you invest in a company, it is because you have conducted a thorough analysis of the company and believe it has long-term growth potential or undervalued assets. You have analyzed the balance sheet and concluded that the likelihood of a significant loss is minimal. Additionally, you understand what the company does and its sustainable competitive position in its market.
When you buy a stock as an investor rather than a speculator, you plan to hold your stake for a long time. If the price drops, you know the reason and can determine whether this is a short-term case or a change that will affect the stock price in the long term. Then you can act accordingly.
When Stock Prices Drop
As long as the stock price is going well, both the speculator and the investor are satisfied.
However, when the stock price begins to decline, that’s another matter. A smart speculator should have an exit plan to prevent small losses from turning into large losses. If you are speculating, you have no emotional attachment to the stock, so getting rid of the loser at a predetermined point is easy.
Some speculators find that getting rid of a stock when it drops by 7% or 8% is a good way to keep losses small. If you set your sell level higher, you risk allowing normal market fluctuations to trigger your sell signal, only to see the stock and market rise again.
Sometimes, you may start speculating but decide you like the stock despite its poor performance, and choose to hold it rather than cut your losses. The speculator has turned into an investor.
Where Speculators Go Wrong
The problem is that speculators often do not know enough about the company to make smart decisions about whether to hold or sell the stock. They are no longer smart speculators and they are no longer smart investors. Any decision they make as an investor at this point will be a guess.
Investors are likely in a better position when things go wrong, but only if they have the courage of their principles. If the stock price drops, reassess the company and the market: Did you miss something? Has something changed? Or is now the right time to increase your holdings?
At the same time, don’t jump on the rule “sell at a 7% loss” if you truly believe in the company’s long-term potential. If you become a speculator at this stage, you are robbing yourself of potential future returns.
Rules for Stock Speculation
To prevent yourself from suddenly switching from a speculator to an investor and losing potential returns, it is important to have a plan.
Apart from having criteria for obtaining trading ideas, speculators should do five things:
- Set a exit point at a loss
- Set an exit point at a profit
- Determine whether to set a time limit for the trade (when the sale occurs regardless of the size of the profit or loss)
- Commit
- Maintain a diary to analyze the success of trading rules
- Identify events that will change your opinion on the company (i.e., when you decide that the investment is a mistake)
- Identify the price that will make selling irresistible due to overvaluation
- Analyze when to add or reduce positions in the portfolio
- Stick to those rules
- Maintain a diary to analyze the success of investment rules
Note: Exit points from a trade do not have to be fixed at a specific stock price. They can depend on moving averages or other technical criteria.
Time limits can be helpful if the fundamental reason for entering the trade is that something is likely to happen soon – earnings, merger, significant regulatory change, etc. When the fundamental reason for entering the trade becomes invalid due to sufficient time passing, exit. This also applies to short-term market movements. If it hasn’t worked within the expected time frame, exit.
Discipline is important here as it forces the trader to be cautious in the initial reasoning. If the reasoning proves incorrect, exit and look for other ideas. Record your thinking in a diary so that strategic adjustments can be made calmly when the market is closed.
Rules for Investing in Companies
The system is not much different for investors. Apart from having criteria for finding companies to buy, as an investor you should:
The main difference in rules between investing and speculating is that speculators look at time frames for their trades.
Note: Selling criteria may vary based on the price-to-earnings (P/E) ratio, price-to-book ratio, enterprise value/earnings before interest, taxes, depreciation, and amortization (EBITDA), or other fundamental valuation ratios. Or it can be relative compared to other opportunities you see. For example, sell to buy something materially better.
It is acceptable to be either a speculator or an investor; just don’t try to be both in the same stock.
Source: https://www.thebalancemoney.com/are-you-a-trader-or-an-investor-3141305
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