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Long Term Investment Plan and Stock Trading

Financial news and print media regularly describes market participants as ‘investors’ and ‘traders’. Investing itself is classified as – long term investing and short term investing. Traders are often classified as – swing or momentum traders. One thing which is common in all scenarios is the will to make money. Both, investing and trading, have made money for their followers. The style you choose largely depends on your psychology. One thing is for sure, if your strategy is based on a hybrid mix of the two, you are most likely to do harm to your portfolio sooner or later.

Investors and Traders

Stock Trading typically refers to buying and selling stocks or other financial instruments with a pre-set goal vis-à-vis their entry and exit point. Stock traders may not necessarily be short term or long term buyers, just those who have a plan. They may hold a stock for months to years or from days to weeks or even for as little as a day (i.s. without an overnight position). The key here is to have an entry and exit plan. Traders often take the help of technical analysis which involves market data analysis such historical price movement, trading volume or trading systems or chart-based techniques to detect short-term or long term patterns. They also buy or sell stocks based on the expectation of some news/event.

A Long Term Investment Plan focuses on building wealth over an extended period of time through the buying and holding of quality stocks. Investors often enhance their profits through compounding, or reinvesting any profits and dividends into additional shares. Long term investment plans are often held for many years, or even decades. By doing this, the investor earns interest income, dividends and stock splits along the way. A long term investor selects stocks after analyzing the fundamentals of a company and the industry in which it operates, to understand its value and its long term potential.

Of course, the intention of both is to make profits but their psychology and styles differ. Most importantly, the discipline with which they go about their business differs.

A seasoned trader keeps a strict stop loss and is happy to take losses in a few trades where his plan does not seem to be materializing. To that extent he does not let his emotions get the better of him. His inherent feature is not to allow huge losses on a single trade. If he is successful in 3 out of 5 trades, he is happy to book losses in the remaining 2. Typically, traders don’t ride on ‘hope of improvements’. This is why we said they have a pre-set goal.

How does an investor differ? Investors have goals too. As warren buffet succinctly puts it “Only buy something that you’d be perfectly happy to hold if the market shut down for 10 years”. This does not mean that investors must always have a long term investment plan. It only means that as an investor, if you are convinced that something is worth holding forever, you will not let short term market volatility discourage you. Unlike traders, investors do not have a strict exit plan if the stock price goes down. They estimate the potential for future growth and are convinced that once the business starts performing as per their expectations, stock price will rise. To that extent, they look at being a shareholder as not very different from being part owners in the business.

What then puts an investor ‘ahead of the curve’? When you compare the two styles, trading is a lot more expensive (and may be a bit more risky), because if you trade frequently, you will rack up commission, taxes and other expenses which will stack the odds against you right at the outset.

Let’s take a hypothetical to understand the impact of brokerage fees and taxes on your portfolio. X is a value investor who likes to buy a few good stocks and has a long term investment plan whereas Y believes in frequent trading to make quick gains.

X invests Rs. 10,000 in five stocks for 10 years at 15% annual rate of return and then sells the investment and pays aggregate brokerage fees and STT of 0.5% (long term capital gain is exempt from taxes in India).

Y invests the same amount at 17% annual rate of return and trades his entire portfolio every year, paying a brokerage of 0.05%, in addition to 15 % tax (short term capital gain tax in India) on his profit.

Note: We are assuming that the trader pays a lower rate of brokerage commission and makes a higher rate of annual return.

Long Term Investment plan

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Now our point is not that traders always suffer. Just that the odds are stacked against them (in our example, about 2.5% from the very outset). Couple this with the thrill of trading and you will see that most of the traders don’t just trade their money once a day but many times over which racks up the brokerage costs even higher. Add a few zeros to the amount at the start and the brokerage costs will look even more deterring.

Last word: Treat stocks like a major purchase decisions. Do not use your cash to buy and sell on hot tips of ‘friendly’ advice. Research yourself and when you have confidence and belief in a business, buy some shares and hold on to them.