You might be confused about the difference between trading and investing. However, there are clear differences between both strategies.
Many young beginner investors see investing as a quick way to build wealth and get rich. The idea, that investing is a quick way to get rich, is often confirmed by stories of people who made significant returns on investments in a short amount of time. However, those people usually didn't make these returns using investing, but followed a riskier trading strategy.
Both investing and trading involve buying and selling assets, like stocks or bonds to make a profit. However, they fundamentally differ in how assets are chosen, how long they are held, and how risky they are.
Let’s dive deeper into the differences between trading and investing and see which strategy is the right one for you.
Traders buy and sell assets with a very short-term time horizon and tend to perform more frequent transactions on an hourly, daily, or weekly basis. Many of them work as full-time day traders who will place multiple orders per trading day.
Their goal is to make quick profits and higher returns than investors employing a buy-and-hold strategy by exploiting mispricings in the market and timing market moves. Therefore, traders hold their assets for a relatively short time. The timeframe may be as short as a few seconds or as long as a week.
You can profit from trading by buying assets that you expect to rise in price and selling them once the price has increased. However, the reverse is also true, as you can sell assets that you do not yet own at a high price and then purchase them at a lower price to make a profit. This investment strategy is called short-selling.
When you actively trade assets, you will base your buy and sell decisions on so-called technical factors, determined through technical analysis, rather than the actual underlying value of the asset, which can be determined using fundamental analysis. With technical analysis, you will attempt to predict the asset’s price movements to exploit short-term price movements. These predictions are usually based on patterns you can detect in price charts for the asset you are analyzing. While technical analysis sounds like a profound approach to investing, it is often more art than science.
“Speculators buy and sell securities based on whether they believe […] securities will next rise or fall in price. Their judgment regarding future price movements is based, not on fundamentals, but on a prediction of the behavior of others.”
Other factors that you might consider as an active trader are the momentum of the asset’s price, whether the share price is perceived to be low, whether the assets category is expected to grow, or recommendations on online forums like Reddit.
Because trading involves many assumptions about the expected price movements and market trends, it is often classified as speculation or gambling rather than investing.
As a trader, you must be very familiar with influences that may affect the asset's price, the latest market trends, news, or social media posts to maintain your advantage and profit. Therefore, trading as an investment strategy is usually boom or bust and only works if you stay up to date on the latest developments.
However, some developments cannot be foreseen. For example, unexpected events like the political upheaval, a natural disaster, a pandemic, or a war might significantly impact your ability to time the market and lead to significant losses.
Investors would simply wait out temporary losses and use these times strategically to purchase more assets if their investment thesis is still intact. However, as traders only hold assets for a short period, they will aim to limit losses and exit their position as soon as possible.
Another common risk is the use of leverage to buy or sell assets. Leverage is money that you borrow to purchase assets. Typical forms of leverage are margin accounts that allow you to spend money you don’t have yet, options contracts that predefine an asset’s buy or sell price, or short-selling. The use of leverage can significantly reduce your investment risk. While it will help you to make larger returns on your trade, losses will also be amplified.
The most common type of trader are probably day traders, who perform a lot of transactions during market hours in the hope of making a positive return. These traders usually close their positions by the end of the market day.
However, there are many other types of traders which are defined by the amount of time they hold their positions, the amount of time they can commit to trading, their personality, their risk tolerance, and their experience.
The most common types of traders are:
Now that you know about the basics of trading, let’s have a look at the pros and cons of trading:
Unlike traders, investors buy and sell assets with a long-term time horizon. Instead of attempting to predict price movements and market trends, investors are more concerned with the future potential of an asset and its real value compared to its price.
“To investors, stocks represent fractional ownership of underlying businesses, and bonds are loans to those businesses. Investors make buy and sell decisions on the basis of the current prices of securities compared with the perceived values of those securities.”
Their goal is to gradually build wealth by taking advantage of the power of compounding. The effect of compounding leads to the exponential growth of the value of your assets. However, it requires you to hold your assets for extended periods of time to start noticing the effects of compounding. In addition, investors have to purchase assets with long-term growth prospects as the effect of compounding might be otherwise reduced.
Overall, investors perform much less buy and sell transactions than a trader would. As a result, they benefit from lower tax liabilities and capital gains taxes than traders who perform more frequent transactions.
As an investor, you can either follow an active or passive investing approach.
Active investors try to beat the market by purchasing individual investments below their underlying value and selling them once the price is close to the asset’s actual value. Once they determine the underlying value of each possible investment, they will pick the ones with the highest gap between the asset’s current price and its real value.
On the other hand, passive investors don’t attempt to purchase an asset below its underlying value. Instead, they will keep buying the same asset at the current market price at a regular interval. Because they keep purchasing assets regularly, the average price they will pay for the asset will resemble the best possible price over the period in which they bought the asset. This approach is called dollar-cost averaging.
We will take a deeper look at the difference between active and passive investing in an upcoming chapter of this guide.
Most investors create a diversified portfolio of assets from different asset classes, such as individual stocks, exchange-traded funds (ETF), index funds, bonds, or others. By diversifying their investment holdings, investors reduce their overall portfolio risk and volatility. The reduced risk allows them to prevent huge losses in market downturns while achieving good gains in positive market environments.
In addition, many investors stay fully invested at all times. By staying fully invested, you can wait out market downturns without the need to realize your losses. This stands in contrast to traders, who will close their losing positions and therefore realize their losses.
Furthermore, the most significant market gains usually happen on a handful of days within the year. By staying fully invested, you can benefit from these gains without needing to predict and time them correctly.
Because investors invest with a long-term time horizon, your day-to-day commitments as an investor are significantly lower than trading would require. For example, if you hold stocks, you only have to check the companies whose stocks you bought a few times per year. After all, company announcements and financial statements are only released quarterly.
In addition, as you don’t have to focus on short-term price movements, you won’t need to pay too much attention to news reports that may cause short-term volatility.
In the end, the required time commitment depends on your investing approach. You may only need to commit a few hours per year if you follow a passive investing strategy. Contrary, you may need to put in more effort if you actively invest and research and pick assets yourself.
Now that you know about the basics of investing, let’s have a look at the pros and cons of investing:
Both investors and traders attempt to profit from value changes in their assets. But while they employ different techniques to make a profit, trading and investing are not mutually exclusive from each other.
While investors have very different investing goals than traders, they still rely on trading to execute their buy or sell orders in the stock market. And many trading techniques, like technical analysis, can still be helpful to find the right time to purchase a new position.
Let’s check out the differences between trading and investing:
It can be thrilling to earn cash as a trader quickly. However, like gambling, it has the potential for huge losses and requires a significant time commitment. On the other hand, investing will lead to smaller short-term wins but is also less risky.
As a beginner investor, it would be best to avoid trading. Instead, focus on setting up a diversified investment portfolio using a passive investing approach. Once you become comfortable with investing, you can start researching your own investment picks and invest in individual investments.
Once you are comfortable with the risks of investing, you may try out trading. However, if long-term growth and reducing risk are your main priorities, you should stay away from trading at all.
Continue with the next lesson of our beginner-friendly guide “Basics Of Investing”.