Full-time investing / trading Part 2 1 comments

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At one point in early 2006 a thread about turning full-time investor/trader was one of the most popular threads in the Channelnewsasia Markettalk forum; the enthusiasm has since subsided dramatically with the recent market correction. On a more sober market mood, it is time to continue on some further discussion of this issue.

My last article with this title outlined the few main issues worth considering in terms of risk appetite, investment horizon and demands for strong mental discipline in a full-time trading/investing life, and yet the most critical issue remains: the long-term viability of the investing/trading approach. Will it be able to provide a sustainable source of income?

Perhaps income is the wrong word, given that "earnings" is likely to be lumpy. But the fact remains that the best way to consider the decision is from the point of a business and the business model: is there a sustainable competitive advantage? In other words, does one see himself being able to attain concsistent returns on capital over the medium and long term?

What is a sustainable competitive advantage in investing/trading? It is probably the Holy Grail and I'd be lying or extremely rich if I can define exactly what it is. Whatever it is, the scaleability of the advantage has to be the key. If one decides that he should turn full-time after doubling or tripling his money in one or two stocks, think again. How sure is he that he wasn't simply lucky in picking these few stocks? Can he be sure that he can repeat these successes? Is he able to scale up his successes on a more substantial amount of capital? Managing $10,000 and $100,000 will be totally different in terms of risk management/portfolio allocation because of differences in personal risk appetite which in turn arises from the differences in the proportion of one's wealth that the investment portfolio constitutes. The trader/investor will be quite willing to put $10,000 into a high-risk stock, say Mediaring, and he would have done very well on it, but would he have scaled up his position proportionately in this one stock on a capital base 10 times that amount? That would be foolhardy.

The scaleability of the investing/trading model, in my opinion, can only be verified through many trades, or what they would call in statistics, samples. Clearly this allows the mean performance and its variability to be established with greater certainty. This actually will mean that short-term traders will be better able than investors to ascertain the viability of immersing themselves in the market full-time due to the high frequency of their portfolio turnover. It also means that one should religiously keep records of one's stock performance for regular monitoring. Of course, I am not saying here that trading is better than investing, I merely suggest that it will be easier for the former type of market player to collate evidence to verify the viability of turning full-time.

What types of competitive advantage are we talking about? I would think that there are three: quantitative, qualitative and behavioural. Quantitative would refer to superior ability to crunch the numbers; arbitrageurs may be the best example of taking advantage of quantitative advantages, but one may also include the ability to parse the latest financial statements, ability to capture breaking news the fastest and hence reap information advantage. Qualitative would be more relating to a superior ability to achieve understanding of the industry and business dynamics, to predict trends, to assess intangible factors like technology and management. The first two relate generally to fundamentals factors; quantitative tends to relate to the shorter-term, while qualitative relates to the longer-term aspects of the business. For behavioural, it refers to the ability to read herd behaviour and generally take advantage of the "random" component of returns (I have described returns as generally composing of a systematic, or fundamentals-based, component, and a random, or behavioural, component: see article on Qualitative vs Quantitative Techniques in Stock Valuation). Perhaps good technical traders would be best classified under this category.

So, which type are you? And do you possess a sustainable competitive advantage in the relevant aspect? Think about it.