Trading Versus Investing

Many people get confused between trading and investing, as on the one hand the goal of both is the same, making money, yet on the other hand when you look at the details they are really quite different. Trading and investing both involve the use of your capital, sometimes leveraged to greater effect as with spread betting, Forex, or commodity trading, with the goal of growing your funds. Generally speaking, anything that you can invest in you can probably trade in too; though there are more ways to trade than invest.

It does not help that we tend to misuse these words, using them interchangeably and even incorrectly in common parlance, for instance talking about our homes as “the largest investment we make”. Except in exceptional circumstances, the home is not an income producer but a net drain on our resources, and many have not even produced capital gain in recent years. Given the nature of people to move house every few years, arguably it could be considered a “trade” rather than investment.

Investing

Considering first investing, it is fairly well understood that this involves using capital with the goal of growing its value over time and/or deriving an income over time. This means investors may be interested in dividends and bond interest payments, for example, much more than traders are. And in keeping with this mindset, once they have made their initial allocations many investors are content to check on their investments’ progress every few months or even each year. In fact, some investments such as retirement funds may be seldom reviewed and reallocated.

Curiously, even though buying stocks is a legitimate investment activity, share buyers are seldom investing to the benefit of the named company. The only time that the company makes any money out of the stocks is during the Initial Public Offering (IPO) when they are sold. Every transaction after that is between third parties.

Part of the investors’ mindset is that there is no predefined exit strategy when the initial purchase is made. The company has been fully researched, sales and earnings figures dissected, and the expectation is that there will be capital growth and quite possibly income from the investment until such time as the money is needed elsewhere. Often the shares will simply form a part of the estate when the investor passes on.

Trading

Trading is concerned with making money by short-term fluctuations in the price of the financial security. In this context, short-term has a wide definition, varying from a few seconds for the really fast-paced daytrader to as much as a few weeks, but seldom longer. Because of this, traders are usually have their exit strategy fully defined before opening the trade – in fact, arguably, it is important for them to do so.

Trades are usually ended on one of three circumstances. Firstly, a successful trade may be closed when it appears that no more may be gained from continuing to stay in the trade – “let your winners run” as the saying goes. Secondly, an unsuccessful trade should be exited before the loss is significant to your account – “cut your losses”. The third, sometimes forgotten, reason for exiting the trade is when it has had a reasonable amount of time to work out, but the price is stuck and seems to be going nowhere.

Almost invariably, a trade will have a limited life expectation, and is much less open ended than an investment. As the world is becoming more impatient, people are becoming more interested in trading than investing, wanting to see rapid results rather than waiting for years to grow their money.

Comparison of Attitudes

This leads to a stark contrast between the attitudes towards the use of the funds in the account. An investor will look at what the price “should” be, given the costs of manufacture and production, both potential and actual sales, and future prospects. The overriding idea is that investments should have the potential to increase in value on the basis of the fundamentals and viability of the business. A stock, for instance, is valued on the basis of its future worth, both in terms of capital gains and dividend income, compared to the perceived risk for the business.

By their nature, traders are much more interested in transient effects, mainly resulting from the psychology of the market and how other traders are reacting. A trader will not be in the market long enough for a significant impact of, for example, income from sales increasing. Certainly, an announced sales increase may result in the share price growing, but mainly in anticipation of future profits, not because of actual cash flow.

Pros and Cons

Nowadays, to some extent investments are looking less secure than they used to. Buy and hold does not necessarily work out in the long run. Investing can still work, and the billionaire Warren Buffett is evidence of this, but he is extremely careful to select the companies that he believes have a long-term future. In comparison, in trading you expect to take an active role in monitoring your account, and therefore you have a closer control on the outcome.

It is not a good idea to consider that you can combine both trading and investing, as they require totally different approaches. In fact, one philosophy could have you buying a stock at the same time that the other approach requires you to sell.

To trade effectively, you need to overcome some natural inclinations, and this can be difficult. Greed, fear, and hope are powerful emotions that are hard to control, but must be conquered if you intend to trade successfully. For instance, when you are losing on what you feel should be a winning trade, the tendency is to hold on in hope, believing that the price will turn around, when you should really be closing the trade quickly out of fear that you may lose more. If your trade is winning, you may be tempted out of fear to close it and capture the gains rapidly, when the correct thing to do is to wait for as much profit as you can get – “let your winners run”.

When you are investing, you are not worried by such concerns. The investor can sleep easily at night, as the approach is not to attempt to “micromanage” by moving in and out of positions, but to let the investments ride the natural ebbs and flows of the market. Although this usually results in some gain over the years, trading to follow price movements is increasingly popular and potentially more profitable.

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