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Trading vs. Investing: What’s the Difference?
Aug 30, 2020 1:41 PM EDT
If you’re new to the world of the stock market and looking to dip your toes into the water, you might be surprised to find that you have more options than you realized. There’s far more than one way to try and play the market.
Two ways to do it, arguably the most common, are investing and trading. You may have conflated the two or assumed that they’re basically the same thing. But they’re not synonymous with one another. Trading and long-term investing are very different things that can have different pros and cons for different investors. So it’s important to recognize the distinction between the two and the various ways in which they differ.
What is the difference between trading and investing, and is one better for you?
Trading vs. Investing
Let’s start by breaking down each one.
In the world of investing, trading is the act of buying and subsequently selling securities in a short period of time in the hopes of making a quick profit. “Short” is a relative term for the time period that can range from seconds to months, but regardless the intent is to sell the security, not to hold it.
Trading often utilizes the stop order. Stop orders, in trading, dictates the price at which you are willing to buy or sell. This can mean a stop-limit order, where you set both a price that would trigger an order and a limit on the amount you will use to buy, or a stop-loss order, which dictates the price that triggers an order to sell. These are designed both to help you buy securities at a reasonable price and help you sell them before incurring major losses (though neither of these are guaranteed).
Trading stock involves a lot of moving pieces, and at times more of a pressing need for the trade to be a profitable one. After all, as a trader you are constantly putting new money into new securities to sell later.
The hope and expectation among many traders is to get a monthly return of 10%. So if you started with $50,000 in your brokerage account for trading, your goal is to have $55,000 in it next month as a result of your trading. Then $60,500 the second month. By the end of that year, a return of 10% monthly would turn that $50,000 into approximately $156,921.42.
Though that’s if you meet your goal; depending on how well you trade throughout the month, you could end up significantly lower or higher than 10% returns.
The most commonly known form of trader in the stock market is likely the day trader, the person who does a high volume of trading during market hours, buying securities and selling them by the close of the market in the hopes of finishing the day with a positive return.
However, there are other types of traders who are categorized by the length of time they hold onto their securities before selling them off. Scalp traders, for example, hold on to securities for as little as a few seconds and not longer than mere minutes. Scalp traders, like day traders, don’t hold positions on any securities overnight.
Swing traders, on the other hand, can hold overnight positions. That’s because they use a more longform approach to trading, holding these positions for days or weeks before selling.
While trading is itself a form of investing, it is separate from long-term investing, the process of buying shares and holding onto them as they increase or decrease in value. Here, you are acting as an actual investor in a company instead of someone briefly owning some of its shares.
Investing means putting in time, possibly even decades if an investment is going well enough, before selling it. As opposed to trying to determine the minutiae of what can happen in the market during mere minutes, you’ll need a long-term outlook. How has this company performed on a year-to-year basis, and is there cause to believe the positives you saw will continue?
This requires a lot of patience. The market is inherently volatile and risky, so long-term investing involves riding out some downturns in the hopes that it will rebound.
You may already technically be investing; if your job offers a 401(k) or an IRA and you are using it, those are long-term investments.
Differences Between Trading vs. Investing
Some of the differences are self-explanatory. Trading requires constant buying and selling, while an investor’s portfolio is filled with long-term securities. A trader sells high while an investor holds on through the various fluctuations of the market.
Here are some of the other ways these two can differ.
Trading may seem like a way to get more money in the immediate future, but you’ll have to consider the capital gains tax. The capital gains tax is applied to any capital gain, and trading involves a lot of buying and selling.
That’s a lot of different gains that are being taxed in a given year if you’re an active trader, compared to one making passive income on long-term investments.
Short-term capital gains and long-term capital gains (the latter applies to assets owned for at least one year) are taxed differently. A short-term capital gain is taxed at a standard rate based on what your income bracket is when filing, which is not true of long-term gains.
In fact, depending on your taxable income, your long-term capital gains could be taxed at a rate as low as zero. Even the highest rate long-term capital gains can be taxed at is 20%, much lower than the highest income tax bracket.
The actual capital gains getting taxed can also differ by whether you’re trading or investing. With trading, your gain is just the return you’re getting from the various trades.
With a long-term investment, though, you may end up with other capital gains to go along with the stock. Many companies offer dividends to their shareholders, on a quarterly or annual basis.
Long-term investments can also have gains unique to those in trading based on how a company operates over an extended period. A company may also, depending on how well it’s doing, decide to do a stock split that can potentially increase the stock price.
A long-term investment can also have compounding interest on it, adding more to your gains.
With trading, you will need to stick with securities that can liquidate quickly. So while other securities can be traded, many stick primarily with stocks.
An investment portfolio that is focused on long-term gains has the opportunity to be much more diverse. Stocks, bonds, mutual funds and ETFs are all common choices. But you can also diversify it with other assets that can increase in value, such as real estate. Of course, securities like these are much harder to liquidate, and that should be taken into account if you’re an investor who wants that.
Whether investing or trading, there’s a good chance that you’ll be using a brokerage account. A brokerage will help to streamline a lot of the moving parts that go on with trading, like the stop-limit and stop-loss orders. But this will come with costs that differ based on which one you’re doing.
Brokerages have commission costs that will cut into the return, and the commission varies from broker to broker. You’ll have to keep the commission in mind when determining what an acceptable return will be, as a return that might look good on paper gets less profitable when the broker gets their cut. And if you’re trading dozens, if not hundreds of stocks a day, that’s a lot of commissions you’ll be paying.
Of course, risk is just the norm with all forms of investing. But different types of risk impact trading and long-term investing differently. The volatility of the stock market means that if something causes a drop-off for mere minutes, the unlucky trader holding onto that company’s shares can find themselves at a loss. If something causes the market to fall significantly on one day before rebounding the next, someone who has been holding onto their shares for years will ride out the downturn and see it rise the next day. But on a bad day for the market, a trader making a mistake can lose quite a bit, impacting their daily, monthly and yearly returns.
Of course, trading can also be a good way to try and mitigate the risk of the market collapsing entirely and the economy going into a recession, as you’re not trying to hold anything for an extended period of time. But a recession could crater the value of a long-term investment.
The luckiest of the lucky investors might do well enough to make their living off investing. Make the right long-term investments, and you’ll barely have to do any work at all to make your money. Keep the occasional tabs on it, and stay aware of how the company is doing and how the market has been performing.
Day trading is more of a time commitment. You’ll need to spend a fair amount of time researching many different companies, deciding whether to make the investment, and staying constantly up-to-date on your brokerage account to see how the returns of your various trades turned out. It can be a lot of work for some investors, but others feel they thrive off the environment.
Is One More Profitable Than the Other?
Trading and investing are both viable and common ways to try and profit from the stock market. But is one more likely to get you a larger return?
Not really. Both can bring in huge returns or blow up in your face. Trading may seem like a way to get higher returns in the moment, but that’s never a guarantee. You’re aiming for a 10% return each month, but a bad day or multiple bad days can put you at a loss. With a serious enough loss, you may not only have lost a lot of your money, but be required to put more of your own capital into your account to maintain the minimum balance. Stock trading brings a lot more risk and requires a lot of knowledge of the market and the ability to make quick decision making.
Long-term investing, though, is also no guarantee at any eventual success. You’re going to need to do quite a bit of research to make sure you’re making the best possible decision for yourself about the company in which you’re going to spend years investing. It’s likely to grow at a slower rate than the ideal trading account would, but over a longer period of time.
Ultimately, the best thing for you when deciding which to pursue is not to consider which one will bring greater returns. Both bring potential and both bring risks. Find the one you’re most comfortable doing and have the best means to do, and do as much research and preparation as you can.
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Trading vs Investing
Differences Between Trading and Investing
Trading refers to buying and selling of stock on regular basis to earn profit on the basis of market fluctuations of price whereas investing refers to buy and holding strategy of investments for long period of time where investors can earn on the basis of interest and can reinvestment over a period of time.
You must have surely heard about people making money from the stock market. Although there are a million ways to do so, we have two broad classifications of stock market activities- Trading (who believe in reading charts) and Investing (who believe in fundamentals of valuation over a long term period).
Before we get into the specifics of trading vs investing let’s understand the difference by looking at the two most influential people in the world of wealth creation, one is known for his long term investments and the other is a renowned trader. If you are a follower of the stock market you might have already guessed the names, they are- Warren Buffet and George Soros. Both have made huge piles of money over their lifetime in the stock market, but differently.
Warren Buffet is worth about US$67 billion who made his money off long-term investments in companies whose stocks he has held for decades. Let’s look at one of his famous quotes.
Conversely, there is George Soros whose net worth is about US$24.2 billion who has made money from a countless number of trades.
Trading vs Investing Infographics
Let’s see the top differences between trading vs investing.
- Trading is done generally by the people who do intraday trading and are always looking for growth investment where technical analysis tools are used, and they predict the higher or lower movement. While an investor, on the other hand, is looking for a value investment and they stick with their investment for a very long time.
- Risk is very high in trading strategy since there is no hedge against this type of transaction, so money at stake is very high without downside protection. On the other hand, an investor might have a properly balanced portfolio where a downside of a particular asset will be upside of others to hedge for the losses.
- The movement in the market and the indexes is generally due to large volumes of trading activity, so in this scenario, traders play a major role to move the market prices as compared to an investor.
- Traders have their own perception of upside or downside and they trade accordingly, they have different types of trading strategies like Butterfly, Short sell, Long Straddle, Strangle and many more, while an investor has a simple and vanilla strategy to hold the asset while investing.
- Returns are pretty uncertain and fast in trading since the transactions of buying selling happen on a daily basis, an investor has to wait pretty long to get handsome returns.
- Everyday crucial piece of information and quarterly results matter to the trader since those kinds of things bring a lot of movement in the stocks allowing an opportunity for the trader, while an investor believes in the value and principles of the company.
Pros and Cons
Trading stocks is much more time consuming and frantic compared to making investments. In case of investments, once you have made sound investments you can simply relax without buying or selling for months/years.
A quote that signifies this difference-
- Making long-term investments requires knowledge of companies’ financial essentials – like Financial Ratios, understanding Free Cash Flows, DCF valuations, relative valuation multiples like PE Ratio, PBV Ratio. Although you have the opportunity to make piles of money quickly with trading the risk involved is much higher in trading than in investments. You could lose more money than you actually have in trading. There is a risk of losing money in investments as well, but that could occur because of the vagaries in the business and due to market timing.
- The cost involved in trading is usually high as every time you trade a stock you will have to shell out certain fees. Hence, your returns need to comparatively higher to cover up those costs. In contrast, you will lower costs since there is less of the buying and selling but then the returns will also be comparatively lower.
- Long term investments are for those people who want to make money but avoid huge losses. You could earn a decent return by reinvesting your dividends and leaving your money In the market for the long term.
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What should you do Trading or Investing?
Try answering the following questions for yourself and you could probably know if trading is the thing for you or investing.
- When deciding between these stock market activities you need to think about the time you can devote to any of them. If you can spend hours reading charts and graphs on a daily basis then trading would be the thing for you. If not then you would be better off with long term investments.
- The amount of equity research that will involve in trading is also much more extensive as compared to making investments. A lot of hard work is involved in analyzing the financial statements, company growth, history and also future financial projections. Those who would really enjoy putting in energy and doing the technical and fundamental analysis religiously should consider playing the market.
- Considering the size of an investor and their goals, if you are a small investor you would be better suited for long term investments with the goal of growing your portfolio whereas if you are a large investor with the goal of short term trading then you should plan to beat the market.
Problem with Doing Both
What when the investments don’t go as per our plan? This is when some of the biggest errors happen. People tend to confuse the investing approach with the trading one and head towards danger. When the stock price is doing well neither the trader or the investor has any problem. But what happens when it does not?
Let’s say the stock price starts falling. As a trader, you would have an escape in order to avert the small losses becoming big ones. Since as a trader you are not emotionally attached to the stock you will get rid of it at the correct point of time. This is rightly what a trader should do.
But there is a problem in case if you decide to keep the stock and not want to give up on it. So here the trader has become an alleged investor who does not have enough information on the company to make a decision of holding the stock or letting it go. As an investor, you would be working on the guess. Similarly being an investor you are not supposed to sell off the stock when the prices go down but believe in the fundamentals and hold on to the stock.
Regardless of which one of them is a better strategy, you should pick one or the other and stick to it.
|Introduction||Refers to buy and sell as per the price movements||Refers to buying and holding the securities for a certain period of time|
|Investment Period||Generally, in this type of activity, the investment is short term and there are quick entry and exit||While here investment is for a long term and exit if far off from entry point|
|Capital Gains||There is short term capital gains and only associated with the upside in security price||Long term capital gains can be earned not only with the upside but also in the form of dividends and bonus on a periodic basis|
|Risk and methodology||Risk is very high since it is short term investment||Risk is lower comparatively as the investment duration is long|
|Types of securities||Only securities or stocks can be traded since there is quick entry and exit||Different types of assets can be invested in a portfolio like stocks, bonds, notes|
|Intention of the investment||The motive is to earn profits and exit the position||Value investment is done on the company’s functionality, banking on the company’s fundamentals|
|Profits||Risk is high, so generally, returns are high too||Limited returns and the profits are reinvested to buy additional stocks|
|Tools used for analyzing||Technical analysis tools like moving averages and candlestick method are used||Financial Ratios and fundamentals of the company are analyzed like P/E Ratio and EPS|
|Investment Strategy||Traders buy the stock to sell at upside and short sell to buy at a lower price||Investors buy the securities to hold and reap the benefits with the company’s growth|
|Protection from investment||Traders typically follow strict stop losses which ensure that they are closing out the loss-making positions at a pre-decided price||Stay put when the prices go down and bank on the company’s performance to do better in future and recover the current losses|
|Tax Pattern||Short term capital gains tax is levied on these returns and the rate is based on your income bracket and is comparatively higher than long term capital gains||Long term capital gains tax is applied on these returns for which the rate can be as low as zero if the returns are yielded after a long period of time|
|Investment Products||Stocks and Options, since you can buy and sell easily on intraday basis and earn the difference||Stocks, Bonds, Hedge funds, Mutual funds, Exchange-traded funds (ETF)|
|Cost involved||Frequent buying and selling of these securities mostly happen in the brokerage account and on every transaction, a brokerage is charged||With a limited amount of transaction, the brokerage fees are also limited|
Why Trading and Investing are Both Important?
Both are interdependent wherein without the existence of traders, investors will have no liquidity to buy and sell stock and without investors, traders shall have no origin from which to buy and sell. Hence, it is difficult to decide which one is superior.
If everyone was an investor, then no one would be willing to sell or buy in the short-term, leading to an unhealthy market scenario. In the end, it is liquidity that tends to smooth out market prices.
If we have to summarize the entire discussion we had on trading vs investing, traders are the ones that take advantage of the market conditions to enter or exit their positions on stocks over a short period of time, taking smaller but much more returns, whereas investors strive for larger returns over a long-drawn-out period by buying and holding stocks.
It is not much of a concern that you are trading or investing, it’s just that you need to be engaged in a chase that suits your personality traits, capabilities, and philosophies. I hope you enjoyed reading this information as much as I did writing it.
This has been a guide to Trading vs Investing. Here we discuss the difference between them, why they are important along with there pros and cons. You may also have a look at the following articles –
Passive vs active investing: Which is more profitable? [Crypto indexing part 1]
A passive investor does not try to beat the market, instead, he invests in vehicles like index funds and ETFs tracking the SP500. An active investor, by contrast, tries to outsmart the market by making active bets such as trying to pick the right stock. These bets make it possible for an active investor to perform better or worse than the market.
The last 20 years a strong trend has emerged within the financial markets — passive investing is on the rise. In 2020 the net inflow from active funds to passive index funds was USD 500 billion, as shown in the figure.
There are good reasons for investors to put their money into passive vehicles. Academic studies have shown that trying to beat the market is an unprofitable strategy. For an overview of the literature see for example Fama’s paper “Efficient Capital Markets” published in the Journal of Finance, 1969. To understand why passive investing beats active, consider the following sequential logical argumentation, written in the form of three statements:
- Active managers cannot collectively beat the market.
- Sub-groups of active investors do not beat their index.
- Top performers do not stay top performers.
The first statement is just plain arithmetic and was proved by Sharpe in his article “The Arithmetic of Active Management” published in the Financial Analysts Journal, 1991. Some active managers must have returns higher the market, and some must have returns lower than the market. As a collective, they will have a return equal to the market. After including fees, however, the collective of active investors will be beaten by the market due to trading costs.
The second statement is proved by empirical studies. Active managers investing in a certain style (e.g. stocks with high dividend yield or small-cap growth stocks) do not beat their sub-index. This makes intuitive sense because almost any style can be replicated with an index, and since indices are less costly than portfolio managers an investor can get the same return for a lower fee.
The last line of defence for active investing is that whilst the two previous statements are true, there exist people who can make the right judgment call and beat the market consistently. Data suggests the opposite. Every year, some investors do indeed beat the market, but these investors are different persons from year to year. By ranking the portfolio managers in one period, and then studying how they performed in subsequent periods, it is evident that the top performers do not stay top performers. This is logical since risk-taking can give extreme returns — sometimes extremely positive and sometimes extremely negative.
The performance of active money managers provides the best evidence yet that indexing may be the best strategy for many investors.
/ A. Damodaran, Professor of Finance at NYU.
More content from the author
Read the next article in this series: Correlations create diversification.
Jacob Lindberg, the author of this post, is the founder & CFO of Vinter Capital — an index provider and data analysis firm specialized in cryptocurrencies.
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