Trading vs. Investing
Generally, investing involves buying shares/stock for long term capital growth. Most people, even those who have never purchased shares before, are familiar with this traditional approach to the market.
For many years a ‘buy and hold’ approach has been the staple menu for many investors in the sharemarket. After identifying a potential solid large company, shares would be purchased and locked away in the bottom drawer. The ownership was similar to a marriage in that it was undertaken for ‘better or worse’.
Through good and bad times, an investor would be secure in the knowledge that the company would pay periodic dividends and that over many years, would return steady capital growth.
Trading on the other hand, involves buying and selling more regularly in the pursuit of small, often and consistent financial gains. People have been trading for many many years and those who are successful generally enjoy all of the advantages listed on the ‘What is Trading‘ page.
There are two main approaches when it comes to analysis of potential companies in which to purchase shares. They are fundamental and technical analysis.
Fundamental analysis involves making an assessment of a company’s operations. It is most heavily used by traditional stockbrokers, fund managers and investors.
Technical analysis is widely used by private traders and is becoming more and more popular. It involves the study of a stock’s actual price, to form an opinion on the likely future direction that the price will move in.
Various factors and information will be considered in a fundamental assessment, including profit, forecast profit, outlook for the industry in which the company operates, key personnel in senior appointments, the members of the board of directors, the main sources of revenue (and whether they can be consistently relied upon in the future) and plans for business growth, to name a few.
More detailed information assessed may include: the company’s ‘EBITDA’ (earnings before net interest, tax, depreciation and amortisation) and the changes to this figure over the last few years; the company’s net tangible assets (NTA); the company’s price/earnings ratio (P/E); the gearing ratio; and other similar data.
Three key financial statements are used by fundamental analysts:
- cash flow statement
- statement of financial position (aka Balance Sheet)
- statement of financial performance (aka Profit and Loss Statement).
All of these statements are found within the annual report to shareholders.
Once an assessment is made of a company’s potential for future earnings (and therefore its capacity to pay dividends or to achieve capital growth in its share price), it can then be determined what the share price should be. This figure is compared to the present share price and a conclusion is drawn as to whether the shares are undervalued, overvalued or about par.
Shares which are assessed to be ‘undervalued’ would appeal to potential investors, seeking to gain from the share price’s anticipated shift from its current level to its (theoretical) true value. Many fund managers use an approach not dissimilar to this one described here.
Fundamental analysts make the assumption that all fundamental information is reflected in the share price of the company. In an ideal and effective market, that is exactly what should happen; however, it is not always what happens. Determining where a share price should be is an incredibly difficult proposition.
Fundamental analysis has two major weaknesses. First, it is difficult to determine what the general consensus will be on information or accounting data released by companies. Essentially, an individual is assuming that what she or he perceives to be solid information or positive sentiment regarding a company’s future outlook is an opinion that will be shared by most other market participants.
Second, as diligent as Government Regulators and various exchanges may be in their surveillance duties, if a company deceives the public through its accounting practices, the effectiveness of fundamental analysis is severely compromised.
An unfortunate reality for shareholders of companies who face liquidation suddenly is that despite the fact that directors may have altered company accounts and misled them, they have little recourse. While the directors may go to jail or be banned from becoming company directors again, that does little to rectify the shareholders’ situation and compensate them if they are left with shares in a company worth nothing.
Fundamental analysis has been used for a long time and is the traditional means by which most investors, stockbrokers and financial industry participants analyse companies for purchase. There is a lot of merit in fundamental analysis, and what it tries to achieve.
One final thought, however — the time it will take for an accurate prediction of share price movement based on fundamental analysis to come to fruition is uncertain. It is very difficult to judge exactly when price movements are likely to happen. One thing is known, though, and that is that anticipated movements are seldom immediate and can take several years to occur.
The main approach for most traders is technical analysis. Technical analysis is the study of actual movements in share price. Despite what people may tell you, there are only two things that move share prices. They are supply and demand — nothing more and nothing less.
When demand for something is greater than supply, prices rise. Conversely, if supply is greater than demand, prices fall. This is absolutely true in the sharemarket.
The cause of supply and demand in the sharemarket could be discussed for hours. Is it profit statements? Is it dividend payments? Is it a fancy logo with a dazzling advertising campaign? No-one can be absolutely sure at any point why people may be buying and selling shares. Herein lies the beauty of technical analysis.
At no time does technical analysis attempt to determine why there might be supply and demand, only that there are certain levels of supply and demand. By studying actual movements in the share price, we can determine, to a great extent, what the present levels of supply and demand for a company’s shares are, what market participants may be thinking and can therefore analyse its potential as an investment.
Technical analysts assume that all fundamental and economic influences on a share price are already taken into consideration in the market, so they simply monitor the price action. Many technical analysts go as far as suggesting that fundamentals are not important and are not worth considering at all. The strength of technical analysis is that you are buying and selling on the basis of the actual share price, rather than relying on hypotheses about future value based on profit statements or performance ratios like the P/E ratio or return on equity figures.
One thing you need to be aware of however. Trading has a greater potential for reward than investing but with that extra potential for reward is greater risk. Those who trade well have been well educated and prepared. Very seldom does somebody start trading and make money from day 1. Often you will hear the saying ‘Only Educated Traders Survive’.