Investing vs Trading vs Hybrid (Part II)

In a previous article (Read more here), we talked about expected return E(R) = (p)(R_W) + (1-p)(R_L).  How do we relate this equation to investing and trading?

The most notable method in investing is the fundamental analysis (FA).  There are many books and articles in the market that describe fundamental analysis.  Just google “fundamental analysis”, it will respond with many results.  Back to our business, how E(R) relates to investing (fundamental analysis)?  The key concept of investing using fundamental analysis is the “buy and hold” principle.   The FA supporters believe that their investment will provide them positive return in the long run.

First, they put a lot of effort in their analysis, baking in a good margin of safety when deriving the target price or intrinsic value.  Second, once they determined the stock is undervalued, the lower the stock price, the happier they are because they can buy more at a lower cost.

What do these imply?

These imply that FA supporters only care about one variable in the expected return equation, which is the R_W.  They assume p = 100% because lower price is a great opportunity for them to buy more, so making the second part of the equation (Risk), zero.

Example,

Michael is a FA supporter.  After rigorous analysis, he came to the conclusion that stock ABC is worth $5.   The stock now is at $3.  Thus, his R_W is 66.67%.  Since his p = 100%, his expected return is 66.67% too.  Michael will invest in stock ABC because in the long run, he believes he will make 66.67% from this investment.

Trading, in contrast, does not advocate “buy and hold” theory.  Most trading believers are short term traders.  Many experienced traders have their own set of rules for trading.  One of them is the cut loss point.  Depending on the trading duration, the profit and cut loss points may vary.  For day traders, the profit and cut loss points may range from 0.5% to 2%.  For traders that have longer trading duration such as weeks or months, the profit and cut loss points may be ranged from 5% to 20%.

Example,

John likes short term trading, using either technical chart or news (rumours) to make a trading decision.  Based on his insight, he believes that stock XYZ will hit $6 in two months.  As the stock is now trading at $4.5, the potential return R_W is 33.33%.  John has a strict cut loss point at $4.  So the potential negative return R_L is about 11.11%.  What is John’s expected return for this trade?

The missing part in this example is the probability, p.  Most traders do not have a quantitative way to determine the p, they base it on their experience and gut feeling.  This is the reason why we always hear people say “you have to pay tuition fees in financial markets before you can make a profit from it”.  For John’s case, let’s assume p = 70%, so the expected return for this trade is (70%)(33.33%) + (30%)(-11.11%) = 19.9%.

All the above examples seem to have good returns on investment.  But all of them share the same weakness – the accuracy of the variables.  If one cannot have a good estimation of the variables in the expected return equation, or half way thru the investing or trading period he or she found will find that their assumption may be wrong, and most of the time this will lead the person into the third territory, which is the Hybrid mode.  Let’s discuss that in part III.