Many individuals we talk to seem to consider themselves as investors and insist that they do fundamental analysis for stock picking. So, we decided to address these two topics in this column. Specifically, we discuss the difference between traders and investors and also show why most individuals may not be actually doing fundamental analysis.
Trader vs investor
It is generally argued that a trader has a short-term outlook whereas an investor has a long-term outlook. But how relevant is long term? Suppose your investments are down 20%. Of what use is an argument that equity generates good returns over the long-term if you need the money to fund your child’s college education three years hence? Whether you invest to achieve a life goal or to capture short-term movements in the market, your primary source of returns from equity is capital appreciation. That means you are exposed to market risk. Therefore, you are a trader, not an investor.
So, who then is an investor? An investor is one who depends primarily on dividend income for returns. It is highly unlikely that you invest for dividends. Why? One, dividends are now taxable at your marginal tax rate, making it unattractive as primary source of returns. And two, given the current level of stock prices, dividend yields are low, unless, of course, your equity holdings have a low-cost basis because you bought these shares long ago.
Of course, many individuals may not appreciate being referred to as traders because they believe such individuals only do day trading. The above discussion, however, shows that traders can have a time horizon ranging from intraday to many years.
Fundamentals vs technicals
Direct investing in stocks is appropriate for the trading portfolio as it is set up to capture short-term movement in stock markets. The optimal way to capture short-term trends is to judiciously combine news with stock trends (read technical analysis).
This poses an issue for many individuals. It takes little effort to read chart patterns after you learn technical analysis. But for most, buying a stock based on five minutes or less of pattern reading is no analysis. That drives these individuals to delve into fundamental analysis.
Now, fundamental analysis is not about reading news and then coming to an intuitive judgment about a company’s business prospects. Nor is it an analysis of past financial performance. If that were the case, equity research analysts may have no role to play in investment management. But analysts do add significant value. That is because fundamental analysis is about forecasting company’s cash flows based on public information and non-material, non-public information and then using a valuation model to price the stock. Individuals cannot engage in this process for two reasons. One, they may lack the time to do such in-depth analysis. And two, it requires good understanding of the industry and the company’s business to forecast cash flows and use an appropriate valuation model to price the stock.
The above arguments are based on the premise that individuals will have two portfolios. One, a goal-based portfolio with equity funds and bank deposits. And two, a trading portfolio with direct stock investments. You do not have to do fundamental analysis for your goal-based portfolios; that is the job of analysts at asset management firms and with sell-side research firms. Also, remember that you are a trader, whether you are investing for your goal-based portfolio or for trading portfolio.
(The author offers training programmes for individuals for managing their personal investments)
