Trading vs. Investing: What Works?

July 30, 2006

Investing for the long term can reap rewards occasionally, but shrewd trading will lock in profits and avoid wild losses. Examine various strategies to discover and take advantage of today’s market.

“Don’t marry your stocks” is an age-old adage on Wall Street. No matter how much you love a company for their products and stock performance, it is imprudent to tie the knot both in sickness and in health. Investing is often considered a long-term practice, but the constant fluctuations that occur make it impossible to get the maximum benefit with a simple buy and hold strategy.

There is a clear distinction between day trading and the trading that I am referring to. Day trading takes the strategy to a level of pure speculation; never holding for longer than a few days, resulting in a strictly theoretical trade that isn’t tied to company performance. Most people who attempt this risky practice end up losing great deals of money by the end of the day, or unsustainable gains.

A popular time horizon for holding stocks is just over a year due to the tax benefit of long term capital gains. Generally, if you hold a stock for a longer than a year, you will pay a lower rate on profits than if you held for under a year. Will you be able to buy the stock at its 52 week low and sell it a year later at an absolute high? Unlikely. By finding attractive entry and exit points, it is possible to outperform the annual performance of the stock. By doing so, any additional tax burden becomes nullified.

What about stocks who fly up with no signs of stopping? With the trading strategy, it becomes difficult to fully realize a company like the Titanium Metals Corp (TIE), which ran up from $7.56 a year ago to $47.63 during May 2006, in an exponential and consistent fashion. However, with the stock currently trading at $29 per share, the benefit of selling somewhere between $30-47 becomes clear.

The psychological aspect of human nature makes it difficult to accept selling a stock at $35, only to see it rise to $47 a month later. The strategy can pay off in the long run though, since all stocks are prone to boom and bust cycles. It is extremely difficult to tell with any certainty if a trade you make is correct; only time can tell.

Selling losing stocks quickly can also be beneficial in limiting losses. Again, psychology is at play since it is difficult to accept any losses or mistakes. Acknowledging errors can curtail future losses from getting out of hand. It is better to get rid of bad companies with diminishing prospects than waiting for the company to turn around. This particularly applies to technology companies who admit accounting scandals. Two prime examples are Rambus (RMBS) and the Marvell Technology Group (MRVL).


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