When you first begin dabbling in stock market trading and investing, most traders and investors lose money. I’ve been trading and investing now for about ten years and during that time, as well as improving my own skills and strategies, I’ve spend a considerable amount of time casually teaching other people.
Many many investors and traders lose money at first. I think the main reason for this is confusion of trading strategies and investing styles. So in this article I want to explain the 3 distinctly different investing and trading styles, the dos and don’ts of each, and WHY investors lose money when they cross strategies.
Shown to yield the greatest returns over the long term, value investing works like this:
The investor carries out a calculation based on company data and making several assumptions (there’s more than one way to do this and some investors have their own bespoke method) in order to come up with a value for the company from which they can calculate what the share price ‘should’ be. One of the most common methods is the discounted cash flow method.
If the current share price is substantially lower than this calculated price, the value investor says to themselves, “The market has it wrong. If I buy now, I’ll make a profit when the market figures out that it has it wrong and eventually gives the company the share price it deserves.”
As such, value investing only works if you have faith that eventually, the market will give the shares their true value.
Because all the calculations are based on company data, changes to the valuations only occur when new company results and reports are released. In the UK, this happens twice a year. In the US it happens every quarter.
The reason newbies get things wrong with this type of investing is because they set stop losses. Stop losses are not needed for value investing.
On the contrary, the cheaper the stock becomes, providing that additional capital is available, the more shares the investor should buy. And every time a drop occurs, value investors will buy more and more stock because they believe that the share price will eventually rise and represent the true value.
From point of purchase of shares until point of sale of shares, a value investment could take 3-5 years.
As such we view Value Investing as an investment vehicle.
Day trading is much more short term. And decisions are made based on stock market charts. In order to day trade you must know how to read a stock chart. This is also known as technical trading.
Only one thing makes share prices rise. And it has nothing to do with how well the company is doing financially. The only thing that makes stock prices rise is more people buying the shares than selling them.
The only thing that makes share prices fall is more people selling the shares than buying them.
Traders make money by correctly predicting what all the other traders are going to do. Stock charts are effectively a record of the mass behaviour of every trader in the market.
So in day trading, you may see that a stock price is approaching what you understand to be a support level. If the support level is respected, this means the share price will turn around and start rising instead of continuing to fall. You might buy in close to or on the support line.
Now, if the stock prices continues to fall, at some point you’re going to accept that the support line was not respected and that the share price will now continue to fall until it reaches the next support line.
THIS is the type of situation when you do need a stop loss. The reason is to conserve capital and get out of the trade rather than getting sucked under and locking the capital up while you ride out the down turn.
What newbie investors tend to do is take a value investing approach to day trading (without doing the valuation calculation) and buy more stock at whatever lower price presents.
Most people end up digging a big hole when they do this, tying up all their capital in a single stock based on no evidence that the business is in good health and likely to rise at some point.
Trades can last anything from a few minutes to several months.
Because of the short term nature of trading, we view this as a money making method rather than a money growing method.
Why Most Newbie Investors Lose Money
Newbie investors typically want short term gains and aren’t willing to wait patiently for the right opportunity. As such, they buy in too early and when the trade doesn’t go their way, they rename it a “long term investment”, by not setting a stop loss (and accepting the loss).
The trouble is they often do this with stocks where they haven’t performed a discounted cash flow valuation and possibly have over-valued shares when they buy in.
They lose patience before they make a profit and eventually decide to “cut their losses”.
If you want to mix approaches, you need to do the valuation first and the technical trade second.