Investing vs. Trading – What is the Difference?
November 28th, 2017 by B&C Financial Advisors
When people find out someone works in investments, that person receives a number of reactions: “So, when is the next correction coming?” “Which stocks should I buy right now?” “How will [some political situation] affect the stock market?”
These questions are interesting, not because they are silly or unreasonable (who wouldn’t like to know the stock market will be going up/down 10% next year?!), but because the answer to most of these kinds of questions is, simply, “I don’t know.” This may come as a surprise to some, but as much as anyone wishes they had a crystal ball telling them which assets to buy and sell every day, the fact of the matter is no one has such decisive information (except for insider traders, but that is illegal), and any prediction—good or bad—should be taken with a grain of salt.
These questions also highlight a very common misconception of what exactly investing is. Investing is buying stocks (and other financial assets) with the intent to hold them for a relatively longer period of time (typically several years or more) to capitalize on the growth of those companies’ earnings. However, buying stocks with the intent to hold them for a relatively shorter period of time (ranging from minutes to hours to days) to capitalize on short-term price fluctuations is called trading.
Another way investing and trading differ is the purpose of each strategy. Both strategies attempt to “buy low, sell high,” but investing is typically a more passive (“buy and hold”) form of income generation used to retain purchasing power by beating inflation, which devalues a person’s money over time if that money is not invested (i.e. $20 will not buy the same amount of goods/services in 10 years as it will today). Trading, on the other hand, is typically done as a hobby, a way to make some money on the side, or a full-time job if the trader is so-inclined, and, because of the relatively short periods of time assets are held, it is considered a more “active” strategy.
Finally, the approaches to each of these money-making endeavors differ. Typically, investing involves buying and holding a diverse portfolio of stocks, ETFs (baskets of stocks), mutual funds, bonds, etc., and making trades relatively infrequently. Investors are concerned with company fundamentals, like price/earnings ratios and dividend yields. While trading can involve many of the same assets investors buy and sell, traders typically process trades more frequently. Because of this, traders generally face much higher cumulative trade fees (the cost to place a trade) and increased tax inefficiencies, as short-term capital gains are typically taxed at higher tax rates. Traders are more concerned with taking advantage of short-term price fluctuations using technical indicators, which are mathematical calculations based on a security’s price and/or volume, such as a stock’s 50-Day Moving Average or a Relative Strength Index.
These differences between investing and trading are important, because while they may seem similar on the surface, the purpose and methods of each vary significantly. Thus, someone looking to familiarize themselves financial markets or get a better understanding of what it is various financial services firms offer should understand these differences before trying to do it themselves or hiring a professional to do it on their behalf.