It is no secret that we here at Caribbean Value Investor Corporation are biased towards the value investing approach to investing. However, given the recent surge in interest in topics such as Day Trading, Cryptocurrency, and Forex Trading, I thought it timely to discuss the differences between the approaches of Day Trading and Value Investing. In this article, we will look specifically at the differences between Day Trading and Value Investing as it relates to capital allocation, time horizon, and expected returns.
I will begin with a layman explanation of Day Trading and Value Investing. Simply put, Day Trading is the act of buying and selling shares within a single day in order to make a profit whereas Value Investing is the act of analysing a business, identifying the value of the business, and buying the shares at a price below that value.
Day Trading Vs Value Investing: Capital Allocation
The literature suggests that one should not be risking more than 2% of his/her portfolio on a single trade. Many traders utilise margin in their day trading practice. By margin, we mean that the trader is using money provided by his/her broker. A Day Trader will therefore sometimes have situations where he/she is deploying more capital than he actually owns. There are also Day Traders that will take bigger risks, such as deploying 30-50% of their capital on a trade based on opportunities that they may observe in the market. A value investor typically invests 70% to 100% of their capital after doing their research in a company. Value Investors typically subscribe to the notion of putting all of their eggs in one basket and watching that basket. The reason a Value Investor will deploy this much capital is that he/she typically waits until conditions are just right. He will then deploy capital aggressively.
Day Trading Vs Value Investing: Time Horizon
Whereas a Value Investor will invest his capital with the expectation for his returns to be made over a number of years, Day Traders invest with a shorter time horizon. As their names suggest, Day Traders tend to want to see their returns in a day. A Value Investor scouts the market for opportunities that might not currently be appreciated by the market and buys into those companies with the hope that in time the market will come to realise the value they have calculated and reprice the stock accordingly. Value investors believe that the market is largely irrational and that a large part of this irrationality is driven by Day Traders. We believe that in the short term some investors and traders make decisions that create opportunities to buy strong companies at a discounted price. Our approach is to buy those companies and wait for the companies to be revalued by the market.
Day Trading Vs Value Investing: Expected Return
The Day Trader deploying huge amounts of capital typically aims to realise a return of 2-5% daily. Day Traders are typically accustomed to higher returns. Value Investors generally display a more conservative expectation of the market in terms of annual returns. One reason for this is that many value investors compare their returns to those documented by other value investors who have been investing over a number of years. One of the most successful value investors is Warren Buffett. His returns have been estimated to be between 22% and 27% compounded annually. To a Day Trader, a 27% return per year might be deemed a tragic underperformance.
To be clear, value investors do not expect that their initial investment will appreciate by 27% each year, rather, we invest in companies at bargain prices such that over a 5-10 year period, the average annual return amounts to something close to the aforementioned 27%. By way of example, today marks the ten year anniversary of Telsa Inc’s (NASDAQ: TSLA) listing on the NASDAQ. The stock which listed at US$ 17.00 per share, traded today at US$ 1,119.63. That’s 6482% since their IPO or an annual return of 648% on your investment. Said another way if you bought TSLA stock on the day it IPOed and held it till today, you would have made 648% on your initial investment for each year you held it. Interestingly, many Day Traders have lost thousands of dollars trading and shorting TSLA stock.