Trading Vs. Investing

Let's begin with a simple illustration, if you go to a producer to buy a given product (let's say, tomatoes) to sell it to another person (a consumer) at a higher price than what you bought it initially, you've made a trade right? You bought goods and exchanged it for money. If you repeat this process and decide to make this your primary or one of your primary occupations, then it could be said that you are a tomato trader.

On the other hand, if you decide that you do not want the hassle of finding tomato buyers or looking for a farmer to supply you tomatoes but you have money and you want to benefit from the profitable business of tomatoes, you can do one of a few things:

• You can agree with a farmer that you would give them your money so they can buy what they need to grow the tomatoes, and in return, you would get a cut of the profit the farmer would make from the sale of the tomatoes they grow plus the initial sum you gave them
• Or you can agree with a trader that you would give them the money they need to buy tomatoes from the farmer, and in return, after the tomatoes are sold, you get a cut of the profit plus the initial sum you gave them

This entire process is simply what investing is. You identify a value chain, you decided that instead of participating in the business, you will give your money to someone doing the business to trade for you, and receive a cut of the profit they made from doing the business.

Let's apply it to an investment that we are familiar with: real estate. Trading real estate would be someone buying/building a house with the sole purpose of reselling it as soon as possible to another person at a higher price than what it cost to buy/build it. The real estate term for this process is "flipping". While if you buy/build a house/apartment with the intention of renting it out, living in it for a while and selling it at a later date, that could be a form of investing.

For stocks, trading would be

• buying (long position) a stock that you expect the price to rise within the hour/trading day, then selling when the price is higher than what you bought it for---like "flipping real estate"
• or selling (short position) a stock that you expect the price to fall then buying back when the price falls to a level you are satisfied with

While investing in stocks would be, buying stocks, holding them for a while, receiving dividends (if they are dividend paying stocks) and selling them after a while.

NB: Stock trading is more complex than this with things like options trading, margin trading, derivatives trading etc. But the essential idea is what is explained above.

Why is it important that you know the difference between trading and investing?

Because as you would come to understand later, while both activities can seem similar, they require different skillsets and mindsets. It can become problematic when you make investment decisions with a trader's mindset or make trading decisions with an investor's mindset.

With the definitions out of the way, let's see the key differences:

The first key difference is the METHOD

Traders make their buying and selling decisions using what is called technical analysis. Technical analysis involves using patterns in market data to identify trends and make predictions. This is where you hear of concepts like lines of support, resistance, pivot points, moving averages etc. The trends that are identified and the predictions that are made are used to take positions (short or long/sell or buy) for each trading day.

While investors use fundamental analysis which involves looking at the company's financial statements like the balance sheet, cashflow statement, profit or loss statement etc.; the prospects of the industry which that company operates within; and the general economic situation of the country/countries which the business operates. The fundamental analysis is done mainly to see the long term or future prospects of a company.

The next key difference between trading and investing would be the NATURE

By nature, trading is a more active endeavor while investing is a more passive endeavor. Trading requires a more hands-on approach. Trading is like a full time business and in today's fast moving world, anything can happen. Traders need to actively monitor the positions they are in so they can lock in profits when they occur or quickly remedy a position if they are making losses. Although with the advent of algorithmic trading (automated trading using computer algorithms) and things like copy trading; trading from the human front can seem to be less active than what it used to be like in the past however, in general, day trading is often a more active venture.

Investing is a more passive action given that investors do fundamental analysis of the businesses they want to invest in, identify the long term prospects of those businesses, and invest with this in mind. Investors are not typically actively responding to the day-to-day goings on the news cycle, if anything, they are more concerned with the long term impact of any new information on the business. If a piece of information cannot be seen to have long term effects, then investors typically do not act on them.

Alternatively, one could invest in a broad index fund like the S&P 500. One may not need to do much fundamental analysis when investing in broad index funds because by nature, those funds do not have the high risk that individual companies in the stock market have.

Another major difference between trading and investing is how they respond to news

Depending on the trading style and level of experience of the trader, how they respond to news could differ.

• Some traders plan their trades before the trading day starts. They look at the news and announcements that are scheduled for the day, do their technical analysis, gauge market sentiments to see what's likely to be announced and they take positions (short or long i.e. sell or buy respectively) based on their analysis.
• Other (arguably less experienced traders) could adjust as soon as the news breaks. So, as soon as an event occurs, they take positions that would allow them to profit.

When investing, as Warren Buffett would put it (paraphrased), "when you invest in the stock market, don't watch the news, don't watch stocks closely".

The advice is based on the idea that if you are investing for the long term, day-to-day news would often not affect your investment in the long run and more often than not, the news could inspire fear and make you sell off at a loss when in fact you should have waited or bought more. If you have done your fundamental analysis right or you invested in a broad index fund like the S&P 500, daily news and market sentiments should be the least of your worries.

Another difference between trading and investing is the TIME HORIZON

Trading is very short term while investing is usually for a longer period. If you buy a stock/house and the price increases almost immediately or within a few days and you sell and repeat the process, that's trading. Investing would be a more long term endeavor.

Something to note here is that: you could invest with a short time frame or trade over a long term time frame. An example of a short term investment could be one that lasts from anywhere from less than a day to 3 months. An example of a long term trade, on the other hand, could be trading in slow-moving securities like treasury bills or trading in assets like gold where a trader could hold a position for years because they believe a certain outcome will occur.

The difference here is, generally, investing should be done with a "long" time frame in mind so if any losses occur along the way, you can wait them out.

The next difference would be based on the RISK

The risk for trading is higher than the risk involved in investing. This is because trading often involves taking quick decisions based on technical analysis which could end up being right or wrong. Remember when I explained that timing the market is quite difficult in this article? Trading is simply trying to find the best times to enter and exit the market which is quite difficult to do even with years of experience and loads of cash because no one can accurately predict the future.

What if the market crashes immediately after you make a trade?

The thing with trading is, you are often using funds that you have to return quickly (borrowed funds) or funds you have to account for daily; so traders often can't afford to stay in unprofitable situations for long.

Here's an interesting scenario: imagine someone that flips (trades) houses. They borrow the money from banks, buy houses and sell in a few weeks or months to pay back the bank and get their profit. Imagine if they bought a ton of houses just before a real estate market crash? How would they sell their houses? How would they recoup their money? Simply put, they could go bankrupt. And that's similar to what happened to popular Finance broadcaster, Dave Ramsey. So, the risk there is high.

On the other hand, given the longer time frame of investments and how one can buy more shares if the price falls to take advantage of dollar cost averaging or just wait till the market recovers, the risk is lower when investing. If the price of real estate crashed immediately after buying in, the owner could maintain ownership of the house they bought, live in it or rent it out while they wait till the market recovers.

PROFITS

Since the risk of trading is significantly higher than that of investing, the profits from trading is also significantly higher than the profits people could make from investing. The simple finance principle of "the higher the risk, the higher the possible return and the lower the risk, the lower the possible return" applies here.

A trader is often making decisions quickly while an investor can adopt a slower approach to making decisions. If done well enough, a trader could almost double their money within a few days-months while investors would do this within a few years.

With all this said, what is the best option for a retail/beginner investor?

As beginners, we often convince ourselves that we have high risk tolerance and are willing to take a lot of risk in the pursuit of great profits. But the reality is, not a lot of us have high tolerance for risk. As traders, not everyday is guaranteed to be profitable. So, if you do not have the grit and the risk tolerance to pull through very high stake situations then maybe trading isn't for you. With the way trading is, you often have to be a quick and smart decision maker because one second/moment of indecisiveness could be the different between a ton of profit and massive loss.

The safer option is investing. Trading requires more knowledge, skill, time and effort to do well; and as enticing as the returns might look, not everyone makes those high returns. As there are winners, there are also losers. As a beginner with little experience, barring a rare stroke of luck, you might not win at the beginning. While chasing high returns from trading can seem enticing, also remember that the higher the risk, the higher your chances of losing your money so while the profits might be greater if you do well, the losses can also be greater if you are not successful.