Investing vs Trading vs Hybrid (Part I)

This is one of the most popular topics among the newcomers who are looking for generating profit in the financial markets.  Investopedia has a good article illustrating the difference between investing and trading (Read more here).  I’m not going to repeat what has been written in Investopedia, I’m going to provide a new way of interpretation for these two methods, from an engineering perspective.  Then I will talk more about the third method, which is the Hybrid mode at the end of the article.

Engineers like to analyze system, and then use the most appropriate mathematical equations to represent the system.  After that, we verify the input variables and constants in the equation, and finally we pull the trigger based on the data!  The engineering way is always safety first, thus one would not make huge mistake and loss their savings in the markets.  On the other hand, the engineering method might not give you supernormal return too, because engineers always work along the highest possibility outcome and stay away from risky zone.

Whether you choose investing or trading, both of them share the same principle – Risk and Return.  The most appropriate equation to represent this relationship is the expected return equation.

E(R) = (p)(R_W) + (1-p)(R_L)

Where,

•       p        = Chances of positive return

•       R_W    = Positive return

•       1 – p  = Chances of negative return

•       R_L     = Negative return

The first part of the equation (p)(R_W) represents the Return while the latter part of the equation (1-p)(R_L) represents the Risk.  Let’s look at one simple example.

There is an opportunity that you can make 10% return with 70% chance of achieving it, but the penalty is 10% loss, do you think it is worth to invest or trade?  Let’s do the math.

10% = R_W

70% = p

-10% = R_L

30% = 1 – p

E(R) = (70%)(10%) + (30%)(-10%) = 4%

What does this mean?

The expected return is 4%.  It means, if anyone tried to sell a financial product to you with 10% return, always ask for the chances of profit and the risk.  Then use the expected return equation to calculate the expected return.  If the expected return is 4%, which is almost same as putting money in fixed deposit account (Malaysian context), do you think it is worth to invest or trade?

Off course it is easy to calculate the expected return, but verifying the appropriate numbers to put into the equation is not straight forward.  To keep the article short, I will discuss that in part II.