The Difference Between Trading and Investing Is Liquidity Risk, Not The Time Frame

Sometimes when I try to engage with people about what I do, I get the response, “That’s great for you, but I’m an investor not a trader.” Normally they follow-up with something like, “I don’t trade. I invest in value stocks for the long haul.”

The difference between trading and investing is a murky continuum. A common approach is to focus on the time frame: investors focus on positioning themselves for the long haul, looking to earn a return over many months or years, whereas traders are hyperactive chipmunks who can’t hold a position for more than a minute without seeing another nut to chase. Trading is short-term, investing is long-term.

I think that this approach takes attention away from a crucial and often forgotten part of the process: The need for someone to take you out of your transaction. I think that if your plan involves eventually selling your asset to someone else, whether that is in 8 seconds or 30 years, then you are trading not investing.

Why is this so important? Because once you need someone else to take the asset off your hands, you cannot ignore considerations of what that person is thinking, how they might value the asset, and how they are financially and psychologically positioned. Those are considerations and risks that are better handled in a trading methodology than an investing one. Investing methodologies tend to assume that asset prices will revert to “true value” over time. Trading methodologies know that markets can stay apparently disconnected from fundamentals for long periods of time due to the needs, position and psychology of market participants.

My definition of trading is broad, and encompasses many things typically regarded as investing by most people, e.g. buying equities under a 401k. If you “invest” in the stock market this way, you do not eat the stock certificates in retirement. Instead, you plan on selling those stocks to someone else i.e. you need another monkey to be willing to acquire your portfolio when you want to extract your money. The price at which they are willing to acquire your portfolio from you will materially depend on their circumstances.

There are things that still count as investing by my definition, and they typically involve coupon-like cashflow. Buying a bond to hold to maturity, for example, is an investment: provided that no-one defaults, you get your money back plus interest i.e you do not require someone else to buy the bond from you. The cash-flows do not have to be guaranteed:  building a factory to manufacture widgets is an investment (building a factory to sell to someone else is a trade). Buying an oil field to pump the oil out is an investment (buying oil futures is a trade). Buying an equity solely for a dividend payment might be an investment, but hardly anyone buys an equity and holds it in perpetuity solely for the dividend: most people assume they can count on getting their capital out at some stage as well.

You can also consider this as liquidity risk. If you need someone to “take you out” of a position in order to make a return, then you are exposed to liquidity risk i.e. the risk that the market may not be able to buy at the time you wish to sell, and vice versa. Different asset types have different liquidity risks: holding a bond to maturity has all sorts of risks (e.g. credit risk) but does not have liquidity risk. Buying stocks for capital gains does entail liquidity risk even if you do not need someone to sell to until 2062.

I am aware that most people are not going to consider a retirement portfolio held for 30 years as a “trade”. However, defining the difference between trading and investment in terms of liquidity risk can focus attention on a crucial and often forgotten part of the process: the need to have someone to buy or sell whenever you want or need to liquidate. There is a considerable risk that the market may not want to transact with you when you want to, and certainly not at the price you might want to transact at. And certainly not if you happen to be part of a larger than usual generation that is all liquidating a similar portfolio at a similar time…. cough baby boomers cough cough.

For my next post, I would like some audience participation please. What is The Number One Job Of A Trader? Please post your answers below, or using the Contact form. Thanks.

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2 Comments

  1. I think this is an excellent post and love the comment “whereas traders are hyperactive chipmunks who can’t hold a position for more than a minute without seeing another nut to chase.” I think using liquidity risk in the definition of trading versus investment is spot on.

    I’ll take a bite at your question, although I feel I am entering a trap….. managing risk.

    Again I am very much enjoying your posts.

    Thanks, Richard

    Reply
    • Thanks for the feedback Richard. I freely admit to being in the hyperactive chipmunk category…

      Not a trap. I have my own answer, obviously, just trying to see how others phrase it.

      Reply

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