Blurred Lines: The Difference Between Trading and Investing
The longest bull market in history lasted from March 2009 to March 2020. When it ended at the beginning of the pandemic, we then saw the shortest bear market ever, finishing just 33 days after the S&P 500 dropped more than 30%. In a bull market, everyone is making money, and it’s easy to pick a winner and believe that the rising tide of a bull market lifts all boats. The sentiment of Warren Buffet’s famous quote, only when the tide goes out do you discover who’s been swimming naked, reminds us that it is during the market volatility many investors are exposed. Over the last year, things have gotten even more exciting, as bored day traders made meme stocks and cryptocurrencies like GameStop, bitcoin, and even dogecoin a hot commodity. These aberrations can cause risky investing behavior to appear more prudent than it is.
So, let's take a step back and understand the differences between investing and trading and the place each of these styles has in an investment strategy.
The Characteristics of Trading
The key thing to remember when differentiating between trading and investing is the goal of the action. When trading, the goal typically isn't to hold a stock for years and benefit from appreciation. Instead, traders seek short-term gains and aim to take advantage of quick drops and spikes in prices. The goal isn't to make a market return – it's to "beat the market."
There are different styles of trading, such as day trading, where positions are typically only held for a day at a time. Then there are also longer-term styles, such as swing or position traders, where they may hold investments for a few weeks to years. Trading requires a lot of time and research. Traders are trying to understand and predict where a stock's price will be at a given point. To do this, they often use technical analysis, such as charting and price history, to look for trends in the market. Since prices are constantly changing, they must act quickly to scoop up potential profits. Traders also often use leverage to amplify the gains (and losses) of small movements in price. Buying assets such as cryptocurrencies are often considered day trades. Even if the intention is to hold them over a long period, they are speculative, putting them into riskier trading categories.
How Is Investing Different?
Investors tend to take a long-term approach to the market. Rather than capitalizing on very short-term opportunities, investors buy stocks or funds whose fundamentals they have researched thoroughly. They create an asset allocation and then select investments that follow a 'buy and hold strategy’ appropriate for a place in a long-term asset allocation; investing aims to create wealth over many years through the power of compound interest and long-term growth of the market.
When taking a long-term approach, day-to-day fluctuations in the market don't have as much impact as they do when short-term trading. In general, the long-term trend of the overall markets is upwards, with some bumpy negative patches along the way. Investors focus on capturing that long-term trend. That's not to say that investors don't periodically make changes; they should. The changes to the portfolio are more often driven by factors such as changing personal financial situation, tax management, rebalancing, and changing market conditions than short-term events.
Deciding Which Strategy to Follow
When deciding whether to trade or invest, it's important to know the goals for putting money in the market. Is the plan to save for retirement or other long-term goals? To try and turn a quick profit? Knowing the end goal will help determine which approach is correct.
With the use of leverage and options, we feel trading is often more akin to gambling for most people. Just like on the roulette table, trading can be fun, exciting, and heartbreaking, all within a very short time. Sure, people can make money quickly, but that goes both ways; people can lose quickly doing it too. Over time, we do not believe the majority of people come out ahead as traders. Please think of this; active mutual fund managers' whole job is focused on picking and trading stocks to beat their index, and they are paid very well for that task. According to S&P, roughly 80% of US stock fund managers have failed to do that over the last ten years. There's a reason research has shown that the average investor consistently earns below-market returns; it's because most of the time, emotions get in the way of a good decision.
It can be easy to get caught up in the buzz around the latest hot stocks. However, frothy markets come and go – and sometimes very quickly. As we saw last year, long-term investments recovered. Short-term trading strategies that were caught in the market's precipitous decline and then rapid bounce back weren't so lucky.
The Bottom Line
While there are increased risks any time money is put into the market, it's important to determine investment goals, purpose, and risk tolerance. There can be a place for a small, satellite amount of speculative investments or trading strategies in an investment portfolio in certain situations. We get it; we are market nerds. It can be engaging, exciting, and fun to trade. It's essential to keep things in context and realize those types of strategies are more akin to gambling than investing. Keep the amounts relatively smaller, and don't put your long-term goals at risk for a short-term bet. More often than not, we believe slow and steady wins the race.
This material is provided as a courtesy and for educational purposes only. Please consult your investment professional, legal, or tax advisor for specific information pertaining to your situation. Investing involves risk including loss of principal. Past performance is not indicative of future results.