Trading vs Investing

Fundamentals · Sep 21, 2019

Is it trading or investing when someone buys stocks? What’s the difference?

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These two terms still cause confusion so, in this article, we’ll explain how investing is different from trading, and we’ll also provide a few simple examples of each activity.

Table of Contents

What is Trading?

In popular movies, traders are those a bit nervous and yelling guys who constantly watch strange candlestick price charts on their monitors. In today’s world, it isn’t precisely how they operate, but the general pace is still fast and trading does requite a strong personality.

Generally speaking, trading refers to a process when an individual actively engages in market operations (such as buying and selling securities) with the goal of generating returns. Sometimes this activity can be also called “speculation” or even gambling.

Active traders (also known as “day traders”) usually execute hundreds of transactions every day. Many of their deals end up in the red but, as long as the gains from profitable operations exceed losses from unsuccessful ones, they are considered to be successful.

To be an active trader, an individual has to be heavily involved in market operations. He/she has to:

  • Constantly monitor traded assets
  • Analyze trends and signals
  • Observe news and even rumors all the time
  • Execute many deals to get the most of the current market opportunities

Traders have a variety of methods to decide which security and when to buy or sell.

Some traders base their decisions on news and “signals”, some use the Elliott Wave Principle or other models. Each professional and experienced trader develops his own unique system that includes several different techniques that suits him personally.

The expected returns of a successful trader may vary, Bob Lotich in his article in thebalance.com mentioned 10% gains per month, but it could be a much lower number. If an active trader overperforms a buy-and-hold strategy of a passive investor by risk-adjusted return, he is doing a good job.

A successful trader has to be fast and flexible, he (or she) has to be able to make money not only when a market index rises and when the economy is doing well, but also during a crisis.

The ability to operate on a falling market is one of the key skills of an active trader.

Trading Example

In one of our previous articles about Apple’s stock we already gave an example of how an active trader might think. Such a trader would determine the lowest and the highest historical price levels, he would then draw a price corridor within which he expects the price to be moving, and he would perform further trades according to this model.

➤ Read also: Support and Resistance in Technical Analysis

A simple trading example would be to buy 1000 Apple shares for $200 and then sell them later for $210 each. This deal would require a capital of $200,000 and it would generate $10,000 of net profit. The price of some assets could change from $200 to $210 in just one day. This example shows why trading is that attractive to people, it opens mind-blowing opportunities to make a lot of money very quickly, but, obviously, there is always a risk to lose money if the market moves in a different direction.

If a portfolio is controlled by a portfolio manager and not by an independent trader, when stocks in the portfolio start to lose their value suddenly, the manager must call the client to inform him about this situation and maybe even convince him to close his positions. As you can see, traders are active and flexible and they have to stay current on all incoming information about the assets they trade. They have to monitor so many things and the picture is never static, it always changes.

Example of a Great Trader

Jesse Lauriston Livermore is a great example of a trader. Although he is often called an investor (even by Wikipedia), his market activities would be better described as trading and Investopedia did just that by placing him first in their list of the most famous traders of all time.

What makes Jesse Livermore a legendary trader and why he isn’t an investor?

Well, he was actively involved in trading in his times (1877 - 1940). He would make a large number of trade deals every day and he was a master of shorting stocks during market crashes.

An investor would buy and hold something for a long period of time, often years.

Jesse’s approach was totally different.

He would conduct deep and careful research on a particular asset, and then he would watch and track it (without buying or selling) for a long time, and when he felt the time to make a move has come, he would perform a quick and massive operation on this stock. If he made the right call this operation would bring him great short-term returns. During the market crash of 1929, he made approximately $100 million and got a nickname of the Great Bear of Wall Street.

Another interesting example of a famous trader is a British broker Nick Leeson, who caused the bankruptcy of the world’s second-oldest merchant bank - Barings, by trading on Singapore International Monetary Exchange (SIMEX).

➤ Read also: Movie Review: Rogue Trader (1999)

It’s a tragic, but also an entertaining film based on Nick Leeson’s story which we wrote about.

What is Investing?

Now that we know what trading is, let’s figure out how investing is different from it.

Investing is a process of allocation money in assets to gradually build wealth. The definition here is quite close to trading, that is why many people confuse those terms, so what are the differences?

First of all, the goal of an investor in terms of the expected margin is much lower than a trader would have.

Investors have to show at least a higher-than-inflation returns at the end of the year. If an investor closed the year with 5-6% in total annual return, this is often considered to be a success.

As long as an investor outperforms the main indexes and the inflation, he is doing quite well. Many investors would name “saving” as their main goal when traders would name something like “money-making” as the goal of their operations. After all, what is the point of being active 24/7/365 on the market if you can’t beat a slow guy, who just bought some blue chips 5 years ago?

The second big difference is that investors are just slower and they don’t trade actively. An investor often executes a small number of deals throughout a year, sometimes even none of them, if he decided that his current positions are solid.

The main difference is about the time horizon of investments. Investing is about a long-term period of 1, 3, 5, or even 10+ years, and trading is about much shorter periods, sometimes seconds. An investor buys an asset to hold it for a long time while a trader buys and sells something many times a day.

Investing Example

Investing in some sense is a more straightforward activity than trading, yet it doesn’t mean that investing is easier. An example of investing would be to buy Tesla stock based on the idea that electric cars would eventually replace cars that run on gas. This is a quite reasonable idea and with that in mind you might want to go even smarter about it, you can diversify.

You could simultaneously do the following:

  • Buy Tesla shares
  • Buy some shares of those car producers who also work on hybrid or electric cars
  • Purchase some shares of companies which produce important parts for electric cars (like batteries)
  • Invest in other clean/eco-friendly companies
  • Sell (short-sell) stocks of oil companies

As you can see, investing can contain a more complicated set of actions on multiple fronts, yet a trader usually focuses on one particular market security as he required to know everything about it at any moment. This idea of clean energy isn’t something that can go away tomorrow based on some news and headlines, it’s a process that can take and will take years, or even decades, but if you are right, you going to have a decent final income after all.

An investor has to play long-term and hold his stocks for a while. He can ignore occasional market hysteria and some downfalls, as long as he believes in his long-term strategy. Plus, an investor can not only rely on the value gains from the stocks, but he could also make additional passive income from dividends. Such income isn’t possible for traders as they don’t hold anything for a long period of time.

➤ Read also: Why You Should Start Investing Early?

A simple example of investing is to spend $10,000 on buying a well-managed and diversified ETF. For instance, Growth ETF (U.S. stock ETFs) by Vanguard, which has 37.26% average annual return for 1 year, 13.20% for 5 years, and 14.59% for 10 years.

Example of a Great Investor

You might have guessed who is going to be here, of course, it’s Warren Buffett.

His approach to investing is perfect to demonstrate what investing truly is.

Warren Buffett always had long-term thinking when it comes to his investing decisions.

He wouldn’t behave like a nervous trader, who is ready to drop an asset any second if there is the slightest sign of trouble. Warren Buffett doesn’t buy stocks, he buys companies, their reputation, and people who are working there, and he does it permanently. If he makes a move on the market (which is easy to see as the portfolio of Berkshire Hathaway is fully transparent), the media will immediately be all over it, because the fact that he picked a certain company is a quite positive sign of long-term health of that company.

Instead of active money management, he supports a passive approach that relies on diversified low-cost index funds. You can learn more about Warren Buffett’s investing strategy here.

Summary of Main Differences

Here are some points that differentiate trading and investing.

Traders:

  • Traders are much more active in the market
  • Traders perform a large number of operations regularly (see “Trading Volume")
  • Traders are active all the time, 24/7/365
  • Traders can’t diversity, they should concentrate on one or just a few assets
  • Traders mostly use technical analysis
  • Traders have short-term thinking
  • Traders can potentially and theoretically earn much higher returns than investors (assuming they take more risk, which is usually the case)

Investors:

  • Investors have a passive market approach in general
  • Investors execute a small number of operations
  • Investors don’t have to be very active in the market
  • Investors can and should diversify their financial portfolio
  • Investors often use the fundamental analysis in addition to the technical one
  • Investors have long-term thinking
  • Investors usually can’t expect a super-high returns

What is Better, Investing, or Trading?

Is it better to be a trader or an investor? What approach guarantees a higher return?

Well, there is no clear answer to this question. It depends.

Theoretically speaking, the potential of a trader in terms of the income is limitless, yet, in reality, no one showed high consistent returns made by active trading for a long period. An experienced trader can overperform an investor during a day, month, or even a year, and there some proven cases of very profitable traders with crazy returns. The problem with traders is that they execute too many operations and it’s harder to track, therefore there are much less famous and successful traders than there are investors. You just can’t point your finger on one deal and say that this deal brought the most of the income, there probably were thousands of those deals. Plus, after a while, the best trader in town might forget about his own rules and risk management techniques like the 1% rule, he might lose everything he made before in just one day and nobody would care about him anymore.

Long-term investors are easier to track and watch, you know what they bought and when, anyone can duplicate their portfolio, but no one knows for sure if a certain portfolio will bring success, it’s revealed only after several years.

Another point here is to say that both trading and investing can be started with a relatively small capital, but active and successful trading can require more money because regular operations involve a lot of transaction fees, so if your capital is small you might not stay profitable even if you are generally successful in your predictions. Trading requires certain personality traits: the power of will, calm character, and strong nerves. Those and some other traits are helpful for an investor too, but at least an investor has some time to make a decision and think about it carefully.

People often choose the best and optimal market approach based on their personal phycology and their age. Younger people may try themselves as active traders and elderly people often end up being passive investors.

It’s a matter of time as well.

To be a trader it has to be your full-time occupation and a job (without a guaranteed salary), but investing can be combined with any other occupation as it doesn’t require that much personal time.

Analytics   Capital   Diversification   Trading   Equity   Finance   Fundamental analysis   Income   Investing   Liquidity   Management   Market   Money   Strategy   Personal-finance   Portfolio   Technical analysis

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