Traders vs. Investors – Who Do You Want to Be?

Let’s accept the fact there are a lot of stereotypes about Wall Street. Most often we are either depicted as testosterone-raged, cocaine-inhaling bros, or we are greedy, capitalist pigs. Many times people apply both stereotypes at the same time. While it’s true that people that fit these stereotypes exist, they are a small minority. Heck, it appears as if some of these caricatures have moved to the world of tech these days, if even a small portion of HBO’s Silicon Valley is true. And yet I wonder why tech doesn’t get the same negative treatment as Wall Street …

But I digress.

The truth is most of us with Wall Street jobs are just regular people with above-average intelligence (nods, pats self on back; so can you for being here) who are good at math and like to analyze everything. As a group we share these similarities, but within this group that is where the similarities end. There are many different roles in the world of investing, and finance in general, for many different talents and personalities. Yet the average person on Main Street thinks everyone on Wall Street plays the same role. I know this because I witness it whenever I tell someone what I do for a living.

So today I want to tackle the differences between trading and investing. But first let me share some excerpts from a short story I’ve yet to release titled, “The Same Thing Happens Every Time I Meet Someone New Who Doesn’t Understand Finance.” (It’s a working title.)

Situation: Any Social Event (Neighborhood Party, Kids’ Athletic Event, etc.)

Other Guy: “So what do you do for a living?”

Me: “I manage money … I work for an investment management firm managing global securities.”

Other Guy: [confusion]

Me: [sigh] “We invest in stocks.”

Other Guy Version 1: [light bulb] “Oh! You’re a stockbroker.”

Other Guy Version 2: [light bulb] “Oh! You’re a trader.”

Me: [sigh again]

I don’t think I’ve met a “stockbroker.” I’m not even sure they exist outside of movies like Boiler Room (which is an awesome movie, but still). But I do know a lot of traders, and they are not the “stockbroker” as depicted in old movies. So let’s dig in and clarify the differences:

Trading

I could go on and on about all the different types of traders and the nuances between them, but for simplicity let’s say there are three different kinds: buy side traders, sell side traders, and prop traders.

Buy Side Traders

Buy side traders are typically execution traders; that is, they execute trades on behalf of the investment team. Let’s say I want to sell out of stock ABC and swap it into stock XYZ. I just send that order to my traders, and they make it happen by using their sell side contacts and the many stock markets around the globe. Their goal is to limit the full cost of executing, called “implementation shortfall,” which means completing the trade with as little negative price impact as possible. Remember that the price of a stock is the balance between supply (sell orders) and demand (buy orders) at that moment.

Depending on the shop, buy side traders can also act like members of the investment team by providing market analysis and information. At other shops, they are treated like second-class citizens. If you want to be a trader on the buy side, look for the former.

Sell Side Traders

Sell side traders act a bit like intermediaries linking buy side buyers with buy side sellers. Perhaps this is where the term “stockbroker” originally came from, but like I said, no one uses that word. A “broker” is a shop that engages in the buying and selling of securities, but the person executing the trades is a trader.

Depending on the shop, the sell side trader might also be allowed to commit firm capital to get trades done. In this scenario, let’s say a buy side shop has a large block of stock they want to sell but their traders don’t want to flood the market with a giant sell order. The sell side trader can offer to buy the entire stake using the bank’s money and then turn around and sell it to others. In this case, the buy side trader gets surety of execution, but the catch is the sell side trader is only going to buy the block at a discount to last price, typically in the range of 2.5% to 5.0% or more depending on the normal liquidity in the stock.

This practice went away in the immediate aftermath of the GFC, as banks had no capital to commit, but it has since come back and can be a very valuable service to the buy side. Now, a word of caution, the sell side trader bears the risk of offloading that stock at a price better than the discount they gave to the buy side trader. This might sound easy, but when you have a lot of shares to move, I assure you it is not. I’ve seen some sell side traders get run over (translation: lost a lot of money) on stocks going against them because something changed in the market intraday. This is not fun for a sell side trader, but it doesn’t happen often.

Prop Traders

Proprietary trading, or prop trading as it is commonly known, is when a trader is given a lump sum of money and told to go trade and make more money with the money they’ve got. It’s a world where the prop trader only makes money by making the firm money. It can be lucrative, but it is also stressful and demanding.

Prop traders love commodities for some reason, so you see a lot of prop trading firms in Chicago since the Merc (CME) is based in Chicago. Prop traders used to be based in banks as well, then called “prop desks,” but new regulations have sought to ban this type of trading, so most of these traders have since gone on to trading-oriented hedge funds to practice their craft. The typical format of these trading-oriented funds is simple: you are given a sum of money and told to use it to make more money in the market. You “eat what you kill” as the saying goes in the industry.

This type of trader has many versions. There are the aforementioned commodities traders, but there are also “hedge funds” that employ prop traders disguised as analysts or portfolio managers. I use quotations because these funds are basically boiler rooms for analysts who are, again, given money and told to make more money by “investing.” You generate ideas and trade your own book, but you’d better make money or you are out. Benjamin Graham defined this as “speculating” decades ago, and the term is still appropriate today.

Once you are ready to graduate from speculating, it’s time to move on to investing …

Investing

What is investing? The great Benjamin Graham attempted to define it as such: “An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return.” The emphasis is mine because I believe that’s what distinguishes investing from anything else that is given the “investing” moniker despite being nothing of the sort.

Investing is analysis.

Investors are trying to ascertain what the future holds for a security based on analysis of all the known facts today. Investors are investing their money or acting as a fiduciary for another to generate a return such that the amount of money in the future is higher than it is today.

Now, let’s be honest, the speculator’s goal is the same, but the difference is the thorough analysis part. An investor leaves no stone unturned and examines every little detail using the mosaic theory to develop an investment thesis.

What further separates the investor from the speculator is the downside protection. Investors hate to lose money because they understand the laws of compound interest and think of the world in terms of percentages. For a simple example, let’s say you have an investment that loses 50%. That now means you need to make a 100% return on your remaining investment just to break even!

Now you know why Warren Buffett gave us his first two rules of investing:

Rule #1 – Don’t lose money.

Rule #2 – See Rule #1.

The investor’s thorough analysis gives some comfort that the security is being purchased at a price where the downside risk is minimal. We are dealing with an unknown future – none of us can predict the future (if I could, I’d be spending my days alternating between the beach and the golf course) – so the investor is going to be wrong at times. This is where the thorough analysis comes in to protect the downside.

Once the investor (analyst or portfolio manager in this case) has a sufficient investment thesis in hand, he or she will hand it off to the buy side trader we mentioned earlier, who will then execute the trade. You can see now that an investor never actually trades a stock. Now, these individual stock ideas are often known colloquially as a “trade,” but in this case, it is a noun since there is no trading of the verb variety done by the investor. Hopefully my grammar nonsense in the last sentence makes sense …

More Than Just Buying and Selling

Now you see why analysts and portfolio managers are annoyed when people assume they are traders, and likewise you can see why a trader is irked when they are assumed to be a “stockbroker.” The takeaway for you is to remember that Wall Street is a large and complex machine with niche roles for just about anyone to play. It’s up to you to follow the path that you want to go down.

So what will it be – investing or trading?