In the financial markets of the world, there are a wide variety of participants each following a specified path to profit. However, among the millions of individuals actively engaged within a given marketplace at a given time, there are two distinct classifications of behaviour: trading and investing.
Investing is the act of pledging one's own capital to an asset or group of assets that may produce a positive return sometime in the intermediate to distant future. Promoted by household names such as Warren Buffett, Charlie Munger and Benjamin Graham, investing commonly adheres to guidelines associated with assorted "buy-and-hold" strategies. The purchase of stocks, bonds, mutual funds or real estate with the goal of long-term capital appreciation are some of the most common forms of investing.
Conversely, trading is an active approach to the financial markets focused on creating an immediate and regular cash flow derived from capital risk. Through daily participation in a market (or markets), traders aim to maximise returns on a per-session basis. Trading operations often include many of the same securities used for investment, but may also include financial derivative products such as futures and options. Currency pairings on the forex are commonly targeted for active trading, because they provide pricing fluctuations that may be capitalised upon in the short-term.
The following are a few primary aspects of market behaviour that illustrate how investing and trading are philosophically opposed:
- Trade duration: The length of time allotted to an open position in the marketplace is a key difference between trading and investing. Investments are often given years or decades to reach maturation, while a specific trade may last only a few seconds.
- Frequency: As a general rule, an investment is executed much less frequently than a trade. Many forms of trading involve carrying out hundreds of individual trades per session, while a typical investment strategy may involve only a few transactions per year.
- Perspective: Perhaps the largest difference between trading and investing is the perspective by which the markets are viewed. Traders typically view the markets in terms of what is happening right now, while investors interpret market behaviour on a much longer timeline. Investors place impetus upon fundamental analysis when identifying opportunity, while traders look to technicals for cues regarding market entry and exit.
- Return on capital: Depending upon the asset class involved, a common rate of return desired by investors is upwards of 6% annually. Traders, on the other hand, look to make in the neighborhood of 10% per month in order to produce an adequate cash flow to cover living expenses.
Investing: Pros And Cons
Investing serves as the traditional approach to financial markets, and is based upon the concept of creating wealth through "putting your money to work." Implementing a capital management approach based upon the tenets of investing affords the individual several advantages:
- Limited short-term liability: Risk attributed to periodic volatilities facing a market or product are greatly mitigated. Investment practices enable participants to ride-out tough markets with the idea that value will return to the investment over time.
- Unexpected capital gain: Unforeseen dividend payments and stock splits are aspects of equities investment that may greatly increase value over time.
- Compounding: This refers to the time value of money contributing to the growth of an asset over an extended period. Revenues associated with interest rates, and their subsequent reinvestment, are a vital aspect of debt instrument valuation.
- Transaction costs and tax liabilities: Because of the limited number of transactions, costs associated with investments are restricted. Also, certain investment accounts are eligible for tax breaks on realised profits.
However, investing also has several drawbacks:
- Availability of capital: Investment capital is typically not readily available until the liquidation of the position.
- Lower rates of return: While diversification and portfolio management work to limit risk, they can also reduce the return on investment (ROI). For instance, according to the 2014 release of Dalbar's Quantitative Analysis of Investor Behaviour (QAIB), the average investor garnered only a 2.6% rate of return for a 10-year period ending 2013.
- Market timing: While exposure to risk related to short-term volatilities is limited, the condition of the market at maturity is a key aspect of realising profit. If the value of the investment is down at the time of liquidation, then realised profit will suffer.
Trading: Pros And Cons
In contrast to investing, trading methodologies are based upon creating revenue in the short term. Periodic fluctuations in the value of a financial instrument are often seen by traders as the preferred avenue for achieving profit. Swing traders, day traders and scalpers all practice methodology akin to short-term trading.
Active trading affords several advantages to its participants:
- Liquidity: Traders open and close positions in a rapid manner. This enables the trading account to remain denominated in cash.
- Exposure to systemic risk: Risks associated with a total market collapse, bankruptcies and dramatic sell-offs are mitigated by an active trading philosophy. Traders are able to quickly exit ominous positions and limit account drawdowns related to unforeseeable market developments.
- Higher periodic returns: Periods of increased profitability are possible. A series of positive trades may generate excess profit that can be used to grow the trading account.
- Reduced risk capital: Through the use of leverage, smaller amounts of risk capital may be used to achieve acceptable profits.
However, in the current digital marketplace, there are several drawbacks to implementing an approach based solely upon active trading:
- Technological gap: Information systems and internet technologies are constantly evolving, requiring active traders to allocate capital for routine equipment and infrastructure update.
- Exposure to short-term volatilities: Volatility can raise its head at any time, in nearly any market. Periodic swings in pricing may lead to a rapid drawdown of the trading account.
- Fees and commissions: Frequent trading practices generate considerable commissions and fees associated with trade execution.
- Tax implications: Profits generated from trading operations are often seen to be short-term capital gains, and are subject to a higher tax liability.
Although the ultimate goal of both trading and investing is to ensure profit through outperforming inflation and the market itself, the processes surrounding each discipline are often at odds. The primary differences between trading and investing lie in how each approach views and conducts market-based transactions.
It is important to realise that neither an active trading methodology nor a long-term investment strategy is the definitive correct answer. Each discipline has numerous pros and cons, and it is ultimately up to the individual to decide which approach is best given capital and risk constraints.
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