When you first enter the financial world, you’re subjected to all kinds of jargon that seem to make the least bit of sense. The stock market is a complex environment, where people follow a million different ways to make their profits. However, all stock-market enthusiasts can be broadly categorized into two kinds—investors and traders.
When you look at the fact that the stock market exists and thrives largely due to the two processes of trading and investing, it does seem necessary to know their inherent differences. Below, we’ll be seeing how trading differs from investing and vice versa.
The Motivation Behind Each Investment Matters
Generally speaking, an investor is someone who looks at long-term returns, while a trader looks at gains in the short-term. Potential investors need to acquaint themselves with market fundamentals like a company’s earnings, P/E ratios, P/S ratios, management forecasts, and so on. When you decide to invest in a company, you’re effectively choosing to invest in its long-term future. Investors usually ride out market downtrends and hold onto their investment, with the expectation that the organization will bounce back soon in the future. Investments are often held for extended durations of time—even decades—and along the way, investors reap the benefits of interest, stock splits, and dividends.
Trading, on the other hand, focuses on the frequent buying and selling of stocks, commodities, and other investment instruments. Whereas investors may be satisfied with a 10% annual return on their investments, traders, on the other hand, are the kind of people who would look forward to a 10% gain every month. In trading, profits are generated by buying stocks at the lowest price and selling them at the highest price, over relatively short spans of time. While investing in a company requires more conviction and commitment from the investor’s end, trading is all about being dispassionate towards one’s investments. Experienced traders have protective stop-loss orders to ensure that they close out losing positions at predetermined price levels. Investors, on the other hand, will ride out market downtrends, with their eyes on the more distant prize.
The phrase ‘short-term advantage’ immediately comes to the mind when one thinks of trading. A stock trader buys or sells as frequently as possible, whenever he or she believes that there is a short-term benefit in doing so. A trader uses technical analysis tools such as stochastic oscillators and moving averages to figure out stock movements, and in doing so, attempts to buy and sell stocks at the best possible price. What the underlying company does or sells is just not as important as their stock movements and price fluctuations. Traders usually belong to one of four categories, depending upon their style of operation. While position traders hold their stock for up to months and years, swing traders hold stock from days to weeks. Similarly, day traders hold their stock market positions for the duration of a day, and second traders maintain their positions for seconds or minutes.
Trading vs. Investing: What’s Better?
Amateurs who have just entered financial markets often find it confusing to decide between being investors or traders. But, such confusion is really baseless. Trading and investing are two processes that each require different kinds of commitment. Trading stocks is, undoubtedly, more time-consuming and hectic than making long-term investments. But, it does not require as much knowledge of a company’s financial fundamentals—essential to a person looking to make a viable long-term investment. As a trader, you will have the option to make boatloads of money as quickly as possible, but, you also run the risk of losing everything that you've invested, just as easily.
Investing requires comprehensive knowledge of the company’s workings; but, once you make a sound investment, you can simply sit back and relax without having to buy or sell for months, maybe years on end. Of course, you still do face the risk of losing money, but that’s because of the fundamental changes in the business itself and not due to market timing. For instance, take the example of Buffett and Coca Cola (NYSE:KO). The Oracle of Omaha purchased a 6.3% stake in 1988 which has increased to 8.8% stake after share repurchases and further investments. The Coca Cola investment over the long term has proven to be one of the most profitable investments of Warren Buffett. This is what an ideal long-term investment could fetch for an investor.
Trading, on the other hand, also has its own set of benefits; take for example, the case of Baxter (NYSE:BAX). Way back, buying the Baxter stock in 1999 before each significant gain and selling it afterwards at the peak price would have fetched a 200% profit. Similarly, short-selling the stock would have fetched a 600% gain for traders during the same year. However, buying the same stock and holding it for a year would have caused a loss. Flash-forward to the present—almost 16 years later—and one can see that Baxter stock has nearly doubled in value, rising from around $31 in 1999 to $70 in 2015.
Why Trading Is As Important As Investing
Trading provides liquidity to the market; simply put, if an army of sellers are willing to sell stocks and an equal number of buyers are willing to buy them, then the volume of transactions in the market go up. If everybody were investors, nobody would be willing to sell or buy in the short-term, leading to an unhealthy market scenario. After all, liquidity tends to smooth out market prices. Long term investment from individuals works out better for companies as it gives them the required time and freedom to grow the company without worrying about day to day fluctuations.
It does not matter whether you are trading or investing, you simply need to be engaged in a pursuit that goes better with your personality traits, ideologies and speculative capabilities.