Investing Versus Trading

March 09, 2012

Investing Versus Trading-How are They Different?
by Cathy Pareto, MBA, CFP® – January 2012

I’m constantly amazed by the number of people who use the terms “Investing” and “Trading” as if they were the same thing, when they are not. There can be a fine line between the world of investing and trading when making profits is the ultimate objective. But, in truth the two are actually remarkably different and employ two radically different mindsets.

Investors are people whose main objective is to generate returns or income from an investment asset over a multi-year or indefinite period of time, regardless of what the price of the asset is trading at. Investors have thoroughly researched their intended investment, have analyzed the asset’s fundamentals and have a strategic purpose for owning a particular position in their portfolio. Investors often look for companies that are “undervalued”, which means that they are intrinsically worth more than their share price suggests. Investors typically have a long term perspective and are not easily swayed by the natural swings in the market. Portfolio risks are managed through the asset mix, namely allocating across different asset categories (stocks, bonds, alternative assets, cash, etc).

Meanwhile, a trader tries to capture short term price fluctuations in securities. They want to generate quick profits and their risks are managed by employing predefined exit points for their positions. Fundamental analysis is not a priority when it comes to trading, instead traders often use technical analysis to determine entry and exit points. Ownership of a particular security will have a finite life in their portfolio. For traders, a holding period could be a few minutes long, a few days long or some other condensed period of time.

Neither trading nor investing is easy. The capital markets are not a simple place to navigate, especially in our current economic and geopolitical climate. While both approaches have surely made people wealthy (think Warrant Buffet—investor; George Soros–trader), my belief is that, generally speaking, long term investing is a far better approach and less speculative approach for most people.

Sure, trading seems to be a much sexier approach to making money. The spin masters at CNBC make it seem so glamorous and easy, right? But with the proper discipline and knowledge, money can be made in a prudent fashion, albeit in a much more boring (but proven) way, simply by investing.

Frankly, I have yet to meet a single individual making loads of money trading the market. Of the traders I have met, many have lost fortunes. Why? Simple–very few people are able to successfully beat the market with their short term trading techniques. I am certainly not trying to pass judgment on this approach, and from time to time, opportunities for a short-term trade will come up in the market and people can take advantage of them. But, it’s hard to do this consistently and if you are planning for retirement, this is not the approach to take. The more actively investors trade, the less they earn, according to a 2004 white paper published by Brad Barber and Terrence Odean, finance professors at University of California.

If your goal is the long-term growth of your portfolio, you need to allocate the majority of your resources to a long term investing approach (buy-and-hold or buy-and-monitor) and limit trading as an entirely secondary strategy for possible entry or exit points into a long term position.