Mindset of an investor

Speculator Vs Trader Vs Investor

You can speculate, trade, or invest in the market depending on how you want to participate. All three types of participation are distinct from one another. One must decide what kind of market participant he wants to be. Having clarity on this can have a significant impact on his Profit & Loss account.

To further clarify on this, consider a market scenario and consider how each market participant (speculator, trader, and investor) would respond to it.

Scenarios

The Central Bank of Bangladesh (BB) is likely to meet in the next two days to declare its current monetary policy position. Because of the strong and persistent inflation, the BB has raised interest rates four times in the last four monetary policy reviews. As we all know, higher interest rates entail weaker growth prospects for Corporate Bangladesh, and thus lower corporate earnings (except for cash heavy companies).

Assume the market has three participants: Kamal, Jamal, and Hakim. Each of them sees the aforesaid scenario differently and, as a result, would adopt distinct market actions. Let us examine their thought process.

Kamal: He considered the situation, and his train of thought is as follows:

• He believes that high, unsustainable interest rates are hampering the growth of Bangladeshi companies
• He further believes that the BB has raised interest rates to an all-time high and that it will be very difficult for the BB to raise rates again.
• He considers what popular analysts say about the situation on television, and is satisfied that his views and those of the analysts are on the same page.
• He deduced that the BB is likely to cut interest rates, if not then it will at least leave them unchanged.
• As a result, he anticipates the market to appreciate.

Jamal: His view of the situation is slightly different. His chain of thought is as follows:

• He believes that it is delusional to count on BB to lower interest rates. As a matter of fact, no one can accurately foresee the actions of BB.
• He is also aware of the high volatility of the market and therefore believes that stocks are trading at overly high premiums.
• From his past experience (via back testing), he knows that the volatility is likely to drop drastically just after a BB declaration.

To bring his idea to life, he sold 5 stocks and plans to liquidate his position just at the time of announcement. 

Hakim: His portfolio is made up of 12 stocks that he has held for 2 years. He is sensitive to the economy, but has no idea what action will BB take. He is also not concerned about the consequences of this policy because he intends to stick with it for the long-term. Therefore, from this point of view, he believes that monetary policy is a short-term market trend and will not have a significant impact on his portfolio. Even if monetary policy is pursued, Hakim has enough time and perseverance to hold his stock.

However, if the market reacts too violently after the BB announcement and his portfolio stocks fall sharply, he intends to purchase more of his portfolio shares.

What the BB ultimately decides and who makes money is not our concern. It is important to distinguish who is a speculator, trader or investor on the basis of their thought process. Each of the three appears to move in the market based on logical decisions. Note that Hakim’s decision to do nothing is itself a market action.

Kamal seems to be adamant about what the BB will do, so his market behavior is aimed at lowering the rate. In practice, it is quite impossible to judge what the BB (or any other regulator) is likely to do. These are complex issues that are not easy to analyze. Decisions made based on blind faith without rational justification are speculation, and Kamal seems to have done just that.

Jamal came to the point of doing things based on a plan. If you are familiar with options, he is just setting up a trade to enjoy the benefit of high option premiums; what BB is likely to do is not important to him, so he is clearly not speculating. His thinking is simple: volatility is high, so the premium is attractive to option sellers. He expects volatility to decline just before the BB decision.

Is he concluding that volatility will fall? No, he does not. This is because he has apparently already tested his strategy, in the past, under similar scenarios. Traders work out all their trades, not just guess the outcome.

On the other hand, investor Hakim seems to care little about BB trends. He believes it is short-term market noise that may not have a significant impact on his portfolio. Even if there are consequences, he believes his portfolio will ultimately head towards recovery. The sole luxury the market has is time, and Hakim wants to make the most of that luxury. In fact, he's even willing to buy more stocks from his portfolio if the market overreacts. He wants to hold his positions for the long-term and not be influenced by short-term market movements.

Each of these three has a different frame of mind, which causes them to behave differently in similar situations. This chapter is about understanding why Hakim, as an investor, takes a long-term view point and is less concerned about short-term market movements.

The Compounding Effect

One has to understand how money compounds in order to acknowledge Hakim’s decision in favour of long-term investment and not really react to short term market movement. Compound interest, simply put, is money that grows when the first year's profits are reinvested in the second year.

For example, let us say you invest BDT 100, which are anticipated to grow at 20% per year (a term also known as CAGR). At the end of the first year, they are expected to grow to 120 BDT. By the end of the first year, there are 2 choices remaining:

1. Leave a profit of BDT 20 invested in the principal amount of BDT 100; or

2. Withdraw profit in the amount of BDT 20.

You decide not to withdraw the profit of BDT 20, but to reinvest it in the second year. At the end of the second year, BDT 120 grows to BDT 144. At the end of the third year, the BDT 144 grows to BDT 173. Here is how it works.

Compare this to the case of withdrawing a profit of BDT 20 each year. If you with drew BDT 20 each year, by the end of the third year your profit would have only been BDT 60.

But since you chose to continue investing, your profit after three years would be BDT 173. Because you did nothing and continued to invest, you made a profit of BDT 13, which is 21.7% more than BDT 60. This is known as the compounding effect.

The chart shows how BDT 100 invested at 20% has grown in 10 years which, if you have noticed took almost 6 years to go from BDT 100 to BDT 300. However, the next BDT 300 was created in just four years, from the sixth to the tenth year.

In fact, this is the most interesting property of the compounding effect. The longer the investment period, the faster and stronger the money works. That is why Hakim decided to continue investing- to take advantage of the luxury that the market offers.

All investments based on fundamental analysis require a long-term commitment from the investor. Investors must develop this mindset when choosing investments