Speculation and trading are two different disciplines compared to investing. Investing requires an entirely different mentality, a long-term mindset and plenty of patience to sit and wait for an investment thesis to play out.
On the other hand, traders are relatively active and can make or lose small fortunes in the space of a day. It requires a different mental attitude based on analytics and an understanding of market psychology to capitalize on market movements.
Unlike investing, traders do not spend days researching investment opportunities. Most of the time, they are reacting to market trends following momentum to capitalize on the herd's movement.
However, there is some overlap between these two disciplines. Most importantly, traders and investors both have to understand how risk works and interacts with different positions.
Understanding risk
At this point, I should try and define what risk really means. For a trader, risk is volatility, but for an investor, the risk of a permanent capital loss is far more important.
These are different definitions, but both are just as important. Traders do not want to be wiped out by taking on too much risk in one position, and investors don't want to end up losing money because they have not done enough research.
At the heart of both arguments are probabilities. Investors and traders both have to calculate the probabilities of certain outcomes materializing and then deploy capital in the most efficient way.
Suppose I am an investor looking at a company with a weak balance sheet but excellent growth prospects. In that case, I have to be able to analyze the likelihood of the business going under. This will involve an analysis of the probabilities and all of the business factors involved.
Meanwhile, a trader will look at the probabilities of their most favorable scenario panning out in comparison to the scenario with the biggest potential losses. Careful risk analysis is vitally important for both disciplines.
Balancing risk and reward
The topic of risk analysis is something Stanley Druckenmiller (Trades, Portfolio) touched on at this year's Delivering Alpha conference. One of the most important trades in his life was shorting the British pound alongside George Soros (Trades, Portfolio) 30 years ago. The traders at the Quantum Fund earned $1.5 billion in a single day when the value of the pound crashed.
They could only earn this return by building a significant position against the currency. They shorted more than $10 billion of the currency, using capital risk analysis to determine their exposure.
Here's how Druckenmiller described the analysis:
"What I did know was that if they didn't devalue in the next six months my fund was going to lose 50 bps. If they did devalue I was going to make 2,000 bps so it was a 40:1 one-way risk-reward bet."
This is why careful analysis of the probabilities is so vital for any significant trades. In just the same way as investors have to weigh up the risks and rewards of taking on a position in their portfolio with a large weighting, traders like Druckenmiller have to analyze the potential losses and potential gains to minimize the impact on their portfolio if they make the wrong decision.
It is also important for investors to try and establish what they would be willing to pay in the worst-case scenario and the trigger points that would cause them to revisit their investment analysis. There's no point in holding onto a stock that has fallen 50% in the hopes that it will turn around. If the picture has changed materially, it could be time to sell.
Analyzing risks and potential rewards are a vitally important part of the investment process. Investors can learn a lot from traders and speculators in this respect.
