Ed Seykota is a well-respected trader who was interviewed in the book Market Wizard. He wrote a foreword in Jack Schwager’s sequel, Hedge Fund Market Wizards, which I find it explained the value of traders and investors alike.
Once upon a time, a drought comes over the land and the wheat crop fails. Naturally, the price of wheat goes up. Some people cut back and bake less bread while others speculate and buy as much wheat as they can get and hoard it in hopes of higher prices to come.
The king hears about all the speculation and high prices and promptly sends his soldiers from town to town to proclaim that speculating is now a crime against the state-and that severe punishment is to befall speculators.
The new law, like oh so many laws against the free market, only compounds the problem. Soon, some towns have no wheat at all-while rumor has it that others still have ample, even excess supplies.
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The king keeps raising the penalty for speculation, while the price of wheat, if you can find any, keeps going higher and higher.
One day, the court jester approaches the king and, in an entertaining sort of way, tells the king of a plan to end the famine-and to emerge as a wise and gracious ruler.
The next day, the soldiers again ride from town to town, this time to proclaim the end of all laws against speculation-and to suggest that each town prominently post the local price for wheat at its central marketplace.
The towns take the suggestion and post the prices. At first, the prices are suprisingly high in some towns and supprisingly low in others. During the next few days, the roads become virtual rivers of wheat as speculators rush to take profits where available. By the end of the week, the price of wheat is mostly the same everywhere and everyone has enough to eat.
The court jester, having a keen sense for his own survival, makes sure all the credit goes directly to the king.
The story is a simple one but it explains the value of traders and investors – discovering the market price of an asset, and reduce the inefficiencies that exist. In the process of doing so, goods are removed from the place which has excess, and got transported to a place with scarcity. I wrote about value contributed by traders and investors previously.
Traders have a Harder Time than Investors
There are no official definitions for traders and investors, but there are vague understandings of it. I will define traders as those who buy and sell liquid financial assets in a short time-frame (less than a year). I will define investors as those who buy and sell liquid or illiquid financial assets over a longer time-frame (more than a year).
The arguments between the trader and investor camps have been long-lasting and it ain’t going to subside in the future. A lot of ego is stating his strategy is superior. I will offer my perspective of it.
Trading can make more money than investing because of higher frequency of profits, and results in capital compounding at a faster rate. But this is the theoretical aspect and it is harder to achieve such results in real life.
As the story depicts – inefficiency in the market must exists in order for a trader or investor to make profits. The price discrepancy between two places encourages market participants to buy low and sell high, reaping the price difference as rewards. As more market participants buy and sell the asset between these two places, the price difference narrows and eventually disappears. The market pricing is efficient and no traders or investors will find it worthwhile to carry out the arbitrage anymore.
Traders like liquidity as they can get in and out of trades easily. However, liquidity signals a higher degree of efficiency. Trading is tough because many traders compete for small inefficiencies that are fleeting. Coupled with algo trading, the space is really crowded and the market is getting more efficient in the shorter time-frame – harder to trade. Only the best traders and the most adaptable can continue to make good money trading short time-frames.
Due to the active participation in the market, traders are constantly exposed to psychological hurts and even trauma. The amount of time spent and psychological pains are the intangible costs paid by traders. Of course, we can also take a positive light to say traders are spending time doing what they enjoy and overcoming these psychological challenges make them better people.
Investors do not require liquidity as much as the traders and since liquidity is a proxy to the degree of market efficiency, investors can find more opportunities in stocks with low liquidity – they are likely to be mis-priced. The only problem is to wait, waiting for other investors or speculators to correct the price inefficiencies in the stocks.
You can make lots of money in trading but it is going to be a lot harder. You can make easier money in investing but it is going to be a lot longer. There is no right and no wrong to which path you take. The game is yours to choose.