There are two schools of thoughts in the financial market. On the one hand, there are advocates for buying and holding assets for several months and years. Examples of these investors are Warren Buffett, Bill Ackman, and David Einhorn. On the other hand, there are traders, who believe in buying and selling assets within a few minutes or hours. In this report, we will look at trading vs investing and the key differences.
What is investing?
Investing is the process of buying an asset and holding it for years. The goal of investing is to buy an asset whose price is relatively cheap and waiting for the price to rise. Also, the goal is to make money from the dividends the firm pays. Warren Buffett is a good example of people who buy stocks and hold them for decades. For example, he has owned Coca-Cola shares since 1985. He has also held into American Express shares for decades.
In addition to stocks, investing also applies to assets like currencies, commodities, mutual funds, and exchange-traded funds (ETFs), among others.
Investors and hedge funds use several approaches to investing. Some of the most common ones are:
- Growth investing – This is the process of buying relatively smaller companies that are showing significant growth. Most of these firms are usually in a stage where they are not making profits. Instead, the investors hope that in future, the companies will get significantly bigger. A good example are investors who bought Amazon shares when it was not making a profit.
- Value investing – This is an investment approach that involves buying bigger companies with little or no growth but those that investors believe are undervalued. To conduct the analysis, they use approaches like the discounted cash flow (DCF) model and ratio analysis.
- Income investing – This is an approach of investing in companies that pay a substantial amount of dividend. Examples of these firms are Procter & Gamble, ExxonMobil and AT&T.
- Sectoral investing – This is an investing approach that involves focusing on individual sectors of the market. For example, technology investors focus on companies in the tech industry while energy investors focus on companies in the energy sector.
- Activist investing – This is method popular among hedge funds. They buy companies and advocate for specific changes.
- Long-short investing – This is a process of investing in companies whose shares they expect will go up and shorting firms they believe shares will fall.
Other investing strategies are events driven, trend following, international, and global macro.
What is trading?
Trading is the process of buying and selling financial assets within a few minutes or hours. Their goal is to identify a short-term trend and take advantage of it. For example, they can buy and sell a currency pair if they see its price rising and exit the trade when it starts reversing. Unlike investors, traders can also make money when the price is falling.
Jim Simmons, who runs Renaissance Technologies, is the one of the best-known traders in the world. According to MarketWatch, his main fund has returned about 66% annually since 1985. That is a significantly better performance than Warren Buffett, who has returned about 20%.
Top trading strategies
Like in investing, traders use several trading strategies to take advantage of market movements. These include:
- Scalping – This is the approach of buying and shorting assets and exiting the trades within minutes.
- Price action – This is an approach of identifying chart patterns and harmonic patterns. Examples of these are triangles, hammer, and cup and handle.
- Trend following – This is an approach where they identify a new trend and follow it.
- Reversal trading – This is a strategy that is similar to trend following with the only difference being that they initiate a trade when they think that a trend is about to reverse.
- Algorithmic trading – This approach involves using computer programs and bots to initiate trades.
Trading vs Investing
There are strengths and weaknesses in trading and investing.
Long term trends change
A key fact about investing is that it is based on forecasting what will happen in the next few years. However, in reality, many long-term trends change. And these changes are hard to predict. For example, a few years ago, ExxonMobil was the biggest company in the world. Investors believed that the shares would keep rising as more people bought cars.
However, these investors did not anticipate the popularity of electric cars and oil oversupply. In the past five years, Exxon’s shares have dropped by more than 60%. The same can be said about other sectors like retail and cruise ships. In trading, you have an opportunity to react fast when scenario changes.
Time spent in the market
Traders spend a substantial amount of time in the market. That is because their goal is to make small amounts of money for many years. Investors, on the other hand, spend little time in the market because they don’t react to short-term swings in prices.
Therefore, if you are a busy person, investing can be a better option for you.
Taking advantage of small market moves
While stocks have historically done well, there are times when significant swings happen. For example, in recent days, the Dow Jones has periodically gained and lost more than 500 points every day. Therefore, while investors have benefited from the overall bullish trend, traders have benefited by trading the short-term swings.
More ways of making money
Stock traders make money only through the price appreciation. This is not the case for investors, who make money in other ways such as dividends and share buybacks. A dividend is the amount of money that is distributed to shareholders every quarter or annually. Buybacks happen when a company repurchases its stock, thus increasing its earnings per share. Therefore, investors win in this one.
Stocks have always done well
Investors tend to always make money in an extended period. For example, while the Dow Jones and the S&P 500 regularly drop, the two indices have returned handsomely to long-term investors. For example, the S&P 500 has returned more than 4,000% since 1970S. Similarly, the Dow Jones Industrial Average (DJIA) has returned more than 3,700% since the 1970s.
As demonstrated in this article, trading and investing have their pros and cons. Investors strongly believe in holding assets for the long-term while traders believe in short-term gains. They are both correct. If you are a beginner, we recommend that you spend a lot of time identifying your sweet spot.