Trading is a business. Like a casino. You spread the risk over a bunch of tables and let the law of averages1 do its magic. Investing, whether it’s a as shareholder, LP, or creditor (ie allocating capital in the primary or secondary markets, but not as a member of management) is something you do in a business. You can invest in a casino. You can invest in a bank. You can invest in a trading business. The point is that investing and trading are actually different.
The distinction seems subtle because the language and mechanics of investing and trading overlap. Traders talk about diversifying as much as investors do. Restaurant owners don’t. Traders and investors both talk about position sizing. Software founders don’t. This makes it easy to confuse trading for investing but the former is a business, not an investment strategy. You would not compare Optiver, Jane Street, or SIG’s returns to a portfolio manager’s. Trading firms think in unit economics just like any business (“how many fractions of a cent of edge do I get per contract?”). The portfolio manager doesn’t have a similar analog. However, if we look at asset management, it collects fees. So if we zoom out, we are at the business-level of abstraction yet again.
There’s an interleaving of concepts that binds notions of “trading” to “investing” in a way that can mislead investors. When they trade are they trading like they are a business, like they are providing a service (temporary liquidity in exchange for a theoretical fee which resolves the desire for a buyer or seller to transact in the absence of a natural counterparty) or are they rebalancing investments? The distinction is one of framing and like all frames, it has a tyrannical grip on one’s downstream decisions. The subtlety can be confusing to new investors who can’t escape terms like “daytrading” or that Robinhood calls itself a “Stock Trading and Investing App”. You wouldn’t take a Porsche off-roading any more than you should confuse these 2 endeavors.
And yet you might for all the superficial similarities I already described. It’s totally understandable. To create the appropriate distance between activities of “trading” and “investing”, I’ll offer 2 thoughts.
- Time Horizon
In trading, the bets have endpoints. Whether it’s an upcoming catalyst or event, an option expiration, or time to roll a future there is a time when you get to “see the river” to borrow a poker term. Price and reality must converge. Extrinsic values go to zero. Future prices meet spot prices. With equities, the metaphor needs massaging. Perhaps news or earnings is more like the “flop” or the “turn” whereas M&A activity serves as a defacto endpoint.
With investing, the duration of the trades is typically much longer. Stocks are perpetual claims. Perhaps semantically awkward, I prefer to re-brand investing as “re-investing”. This focuses us on a company’s need to compound returns on capital internally. If an oil company sits on massive reserves, but the price of oil shoots to a price that destroys all future demand, the stock would plummet because it no longer has a forthcoming stream of earnings. Yes, its book value would immediately increase, but that is a smaller portion of its discounted perpetuity value.
The “re-investing” frame explains why a market would discount such a one-time windfall. You can even think of a “cheap” stock as a company that the market has decided has a low future return on invested capital. By not increasing their bids, investors are manifesting trader thinking — they are focused on return per trial. Thinking of investments through the lens of how a company re-invests, stretches “repeated game” thinking longitudinally into the future as opposed to traders or casinos who think of edge per trade cross-sectionally.
- Seeing The Present Clearly
Since the compounded return of an investment depends on how a company re-invests, it requires distant foresight into an inherently complex system. Long-term investing, like long-term weather forecasting has an irreducible bar of uncertainty that sits unpleasantly high off the ground. There’s only so much you can say about a system governed by chaos, biological, and evolutionary forces as opposed to tidy physical properties. Feedback loops are long, causation is opaque, and the signal-to-noise ratios are too low to prove an edge. This leads to a paradox. If a manager’s edge is unprovable, then there’s a chance you can actually access it, you’ll just understand it post-hoc. If the edge was provable, the manager would extract all the excess alpha for themselves by either choosing strategic investors or charging ransom fees.
Trading on the other hand is a provable edge. Because it’s a business. You rake a tournament, take the profits off the table and hunt for new players. Markets might imply or try to tell us something about the future. The business is to find market prices that say something contrary but have visibility to resolving and taking both bets. Arbitrage is an extreme example of this. If one person thinks the USA basketball is 90% to win the gold and another thinks the field is 15% to win the gold you can bet against them both and get paid $105 while knowing you’ll only owe $100.
The business process around this involves measurement, not prediction. There’s no thematic vision of what the world looks like 10, 20, 50 years hence. Instead, you find others who express strong opinions that disagree and build a machine that lets you bet against both of them. You are passionately agnostic. You are in the business of seeing today clearly. Not having visions of the future. That’s your customer’s job. That’s the investor’s job.
A Skinny Bridge
Coming from the trading world, I’ve wrestled with my understanding of investing. I don’t believe in crystal balls. I don’t think any “long term” investor can prove they are special because of the limits of data and sample size. Putting faith in track records feels like betting on coins that just had a long streak. There are a lot of funds out there, it’s inevitable some will have long streaks by chance. Survivorship bias makes the proportion of lucky funds even more visible.
This is a discouraging place to settle. Attempting to invest in a trading business as opposed to doing the trading business, leaves you in the epistemological rut as choosing any business to buy. They are just businesses, to be compared with any other business. In fact, the search is pointless. Most are capacity constrained which means the best ones don’t need your money anyway. Where does that leave me? I don’t trust most people who would take my money to manage it and I don’t have the expertise to invest to the impossible standard of risk-reward that the business of trading anchored me to. And I need to take myself seriously — I just spent this entire essay explaining how it’s a fallacy to compare trading to investing in the first place.
Is there a reconciliation?
I think so. I see a skinny bridge between the business of trading and what it prescribes for investing. It lies in portfolio construction and asset allocation. At one level of abstraction, the investors with their coherent visions of the future are simply tourists in the traders’ casinos. But if we zoom out and aggregate the consensus of competing investors we end up with a total market price. It’s not one market however, it’s many. There are equities, bonds, and commodities. They exist across geography and sovereign systems. These are the legos that can be stacked to construct payoff shapes — carry, insurance, momentum. Those can be described in other language as well — concave/convex, convergent/divergent.
The asset classes themselves contain a risk premium above risk-free rates (by induction — stocks should earn more than t-bills because you need extra compensation to hold something that tanks every now and then). By combining these asset classes under battle-tested principles of risk management, the hope is to capture the weighted average risk premium of your allocation without relying on forecasts. Just like trading businesses. Just like casinos2.
Trading and investing are sufficiently different that you should be conscious of what mode you are in when you click a buy or sell button. The awareness will likely lead you to pressing buttons less often, or systematizing when you push the buttons. Unless you’re in it for the thrill, you want to minimize your points of contact with the fee-generating businesses that want you to feel like you are doing a good thing by “investing”. You are doing a good thing when you invest, but be careful — sometimes what looks like investing is trading. And the bar for doing that productively is much higher than they want you to believe.