Reed C. Fraasa, CFP®, AIF ®, RLP ®
Arthur Conan Doyle, the author of Sherlock Holmes, said, "It is a capital mistake to theorize before one has data. Insensibly one begins to twist facts to suit theories, instead of theories to suit facts." Doyle's observation was over eighty years before the development of 24-hour cable news and the internet.
Investors
As investors, we get to choose how to manage our capital, and everyone has several options to consider. We may decide to avoid the risk of loss and keep our capital in cash equivalent instruments like savings accounts, bank CDs, money market funds, and government T-bills. We may decide to accept some risk of loss and deploy our capital to other financial markets, including stocks, bonds, and real estate.
The two primary reasons to take the risk in stocks, bonds, and real estate are:
1) to achieve a higher return than inflation on capital (a real return)
2) to fund specific goals by forecasting contributions to capital and gaining a real return on the capital (financial planning).
The wise investor targets a long-term return for their capital expected to outpace inflation and achieve their financial goals.
The wise investor follows a personal benchmark and does not always try to beat the market.
Traders
Traders try to beat the market by considering all the available data and, with some intuition, select superior securities and time when to buy and sell those securities.
Professional traders serve an essential role in financial markets by providing liquidity (someone is willing to buy when we desire to sell). The cumulative effect of their trading reflects the current price and value of financial markets.
The Accidental Trader
Most investors are risk-averse, meaning that the pain of experiencing a loss is considerably more significant than the pleasure of achieving a gain. Risk aversion leads investors to lower returns with known risks rather than higher returns with unknown risks.
Their perception of current financial risk, primarily influenced by daily breaking news in the media, compels investors to start behaving like traders with their long-term capital. When this happens, the investor will often make short-term decisions with their long-term money.
One of the most common questions we hear from investors is why the stock market moved in the opposite direction than what the data seemed to indicate.
In 2020, the stock market has been going up when COVID-19 and economic news is not improving. The feeling that the available data does not justify the market's value leads people to perceive that there is more risk in the market and cause them to sell out of the market. Behaving like a trader when we are an investor, is not prudent.
For instance, the Federal Reserve recently reported that economic data shows the economy is stagnant. The focus is on improving employment and letting inflation run higher without raising interest rates for the foreseeable future.
Some traders interpreted that news to read that the economy will be positive for business and consumer spending, indicating company earnings will grow and the stock market valued higher in the future.
However, other traders may interpret the same news to read the economy is worse than expected. We may be heading into a prolonged recession, which could negatively impact earnings and result in a decline in future stock prices.
The difference between the two interpretations in the previous example is likely due to personal bias like the glass is half full or half empty.
As Arthur Conan Doyle cautioned, many traders often start with a point of view (theory) and then look for information (data) that confirms their belief. Investors should avoid this type of short-term tactical thinking.
An example will illustrate the difference between an investor and a trader. Suppose two people plan a trip from New York City to Washington DC.
The investor decides to take the train and accepts that it will take about 4 hours. While on the train, they spend time reading and doing work on their computer.
The trader decides they can get there quicker by driving and using Waze navigation on their phone to drive faster and avoid any traffic and police radar. They spend the time interpreting traffic patterns, frequently switching lanes, and monitoring the data from Waze.
On any given day, the trader may beat the investor to Washington DC or back to New York City. However, over the years, the difference will start to diminish. The trader may still have saved some time overall, or they may not, but the investor also was more productive and less stressed during those trips.
Don't let current events sway you from your long-term plan for your assets. Determining your capital's most appropriate allocation for the risk and return you expect and then sticking to your plan will increase your odds of success. A considerable amount of data backs that theory.
Author’s Bio
Reed C. Fraasa is a CERTIFIED FINANCIAL PLANNER™ and founder of HIGHLAND Financial Advisors, a Fee-Only financial planning firm that offers comprehensive financial planning, retirement planning, and investment management. Reed has 30 years of experience as a fiduciary advisor and is the author of The Person is the Plan®, a unique financial planning process. Reed was a frequent guest contributor on PBS Nightly Business Report and has been featured in the New York Times, Wall Street Journal, and Star Ledger newspapers.