Activities in the financial market are rapidly becoming popular amongst individuals. Since technical information about the financial market is now readily available to all and sundry, there has been an increased level of participation in the market. One can profit from the financial market via a number of ways, and two of the most popular ways are Investing and Trading. These approaches to wealth creation in the financial market are continuously interchanged and mistaken for the same, however they are essentially different. Although they both aim to acquire wealth in the financial market, these concepts have basic technical differences, as there is always a misunderstanding of trading vs investing.
In this article, you will be completely exposed to these two concepts in the financial markets. Each of them will be thoroughly explained, their intricacies will be deciphered, and their many differences will be revealed.
What is Investing?
Investing is often misused in the financial world. Basically, investing involves committing capital to an endeavour with an expectation of gaining profit in the future. Investment is usually done with a long term approach in mind. The potential of benefiting and receiving money in the future is the reason why people invest. Investments are often held for a long period of time – years or decades. Investors always look to take advantage of stock splits, interests, and dividends over this period of time.
How Investments Earn Money
An Investment is an asset that is purchased or into which capital is put with the expectation that it will provide income in the future. There are three main ways through which investments earn money or generate income, they are: Appreciation, Interest Payments and Dividends.
Appreciation: Appreciation of an asset or investment simply means that the value of such entity has increased over a period of time. Also known as capital growth, Appreciation is measured based on the current value of the asset or investment, against the original amount invested in it. The Capital growth quota of any investment is all the market value surpassing the original investment. Appreciation of an asset is usually one of the most important investment goal of any investor. There are several reasons why investments appreciate, some of which are macroeconomic factors. A basic example of Appreciation is if you purchased an asset for $200 and three years later, it is worth $500, then we can say the asset or investment appreciated in value.
Interest Payments: This is another way by which investment or assets can generate wealth for investors. Interest payments are usually paid on debt instruments as a compensation to the investor for loaning his principal capital. Several types of investments make interest payments, such as:
- Fixed Income Securities: Examples of these are bonds, and the interest rate is always preset and lasts until such security gets mature.
- Demand Deposits: Depositors always receive interests as a compensation for keeping their money with depository institutions.
- Fixed Annuities: These investments pay a set interest rate on a basis of tax deferment up until maturity of the investments.
- Seller-Financed Mortgages: In this kind of investment, the seller charges an interest rate on the principal amount loaned to the buyer.
- Mutual Funds: Any mutual fund that invests in any of the above benefits from interest payments.
Dividends: These are payments made to investors by companies whose equity or stocks they own. Public companies usually issue stocks as a way of raising money for business activities, enabling investors buy those stocks. Payment of dividend is done as a way of sharing company profits with such investors, however not all stocks pay dividends. Dividend payments must be permitted by shareholders and could be organized as a one-time special dividend payment or as a continuous cash flow to investors. Dividends are typically issued as cash payments, but can also be shares of stocks or other properties with value.
Types of Investments
There are several methods or groups of classifying investments. One of the broadest and important classification is grouping investments based on the nature of their income. According to this classification, investments can be grouped into Fixed Income Investments and Variable Income Investments. We will proceed to properly dissect these two types of investments, revealing all there is to know about each one of them.
Fixed Income Investments: A fixed income investment is one that provides a set amount of income in the form fixed periodic payments. The payments of a fixed income asset or investment is known in advance, and there is an eventual return of the principal capital at maturity. Generally, fixed income investments usually yield a low return on investment because they promise income. There are several types of fixed income investments such as Treasury Bills, Corporate Bonds, Municipal Bonds, Certificate of Deposits (CD), amongst others.
Variable Income Investments: A Variable Income Investment is one that provides a dynamic or changing amount of income that is determined by underlying market forces. Variable Income Investments usually provide their owners with a very high return on investment, however they are more risky endeavors than fixed Income investments. Some types of Variable Income Investments are Variable Rate Demand Obligations (VRDO) such as Municipal Bonds, and Floating Rate Notes (FRN).
It is worthy of note to mention another classification of investments. Based on the manner of investment, we can classify investments into three –
- Ownership Investments – which include Stocks, Starting a business, Real Estate, Buying Precous objects, etc.
- Lending Investments – which include Bonds, Savings accounts, etc.
- Cash Equivalents – such as Money Market Funds.
What is Trading
Trading basically involves the frequent buying and selling of securities in the financial market. Trading is usually done with a short term approach in mind. It is very common for traders to own stocks for less than a day or month. Market trends are what guides Traders in making stock trades, as the aim of trading is not long term growth but short term gains. Trading profits are commonly generated by buying securities at a lower price and then selling at a much higher price all within a short period of time. Traders are known to usually employ various technical methods to effectively predict high-probability trading setups.
There are several types of traders, according to a “trader’s style”. Trading style refers to the time length or holding time during which stocks or other trading instruments are bought and sold. According to this, traders can be classified into four major categories. They are:
- The Scalp Trader: This type of trader holds trading positions from seconds to minutes or hours, with no overnight position held.
- The Day Trader: This type of trader holds trading positions only throughout the day, ensuring no overnight position is held.
- The Swing Trader: This type of trader holds trading positions from days to weeks.
- The Position Trader: This type of trader holds trading positions from months to years.
There are several factors that determine how long a trader holds a trading position for, some of these are level of trading experience, capital size, expected income from trading, risk tolerance, etc. Essentially, traders always look to take advantage of market trends, so as to enter and exit trading positions over a short period of time, all in a bid to make frequent profits.
Differences between Investing and Trading
For a long time, investing and trading have been confused in the financial sector. In truth, their differences are very subtle and technical, which is why we have taken time out to properly define and explain each one of them before proceeding to their differences. If you have ever wondered what distinguishes an investment from a trade, then you are in the right place, as we will reveal all of this to you. You will be exposed to a comprehensive and insightful explanation about what essentially makes these two methods of wealth creation quite different. Now that we have explained what is investing and what is trading, these are the differences between trading and investing:
Frequency: The frequency of purchase of stocks or other financial instruments is a key distinguishing factor between traders and investors. Traders are known to buy and sell multiple financial instruments within a day, whereas an investor might make only one purchase or sale in a year. Also, investors usually have a few stock picks for a particular year, whereas it is very common for a trader to place bets on hundreds of stocks in a year.
Time Period: The time length or period for which a stock or financial instrument is held is also a major difference between a trader and an investor. A trader is typically focused on entering and exiting a trading position within seconds or minutes, whilst an investor can hold a stock for years upon years. Traders hold stocks expecting a short term high performance, whereas investors follow a buy and hold principle whenever investing, as short term market changes are always considered irrelevant by investors.
Capital Growth: Whilst traders and investors are both looking to create wealth and profit from the market, they both have different capital growth expectations or profit goals. An investor might be comfortable with making a 20% yearly portfolio growth, but this will be considered very small by a trader. Traders are always looking to earn massive capital growths on their investments over a very short period of time.
Risk: It goes without saying that both investing and trading pose a risk to the initial capital put into the endeavor, however the level of tolerance of risk varies greatly between a trader and an investor. An investor has very little tolerance for risk and is always satisfied with lower returns over a period of time, whilst a trader encounters higher risk in his quest for a high return on investment over a very short period of time. Both parties have very different threshold for risk acceptance. For instance, a trader and an investor might hold the same position in the same stock, however a 7% drop in the value of the stock at noon is most likely enough for the trader to pull out of his position on the stock, however it will be considered inconsequential by the investor since he aims to hold his position for a long time.
Types of Stock Bought: The types of stocks bought by a trader is distinctly different from that bought by an investor. Traders always go after volatile stocks in very high volumes, ensuring they can cash out within a short period of time. Investors on the other hand are after stability, focusing on stocks with a bright future, as volatility is a red flag for an investor.
Taxes: Since one is taxed differently depending on how long one holds a stock for, traders always face a higher capital gain tax than investors. Capital gain taxes are grouped into short term and long term, and one holds a stock for less than a year, one gets to pay the short term tax which is higher than the long term tax. This is another fundamental difference between trading and investing.
Depth of Analysis: The depth of analysis of stocks or companies is typically different between an investor and a trader. Given that investors are always looking to hold stocks or other financial instruments for a long time, they always make sure to perform in depth analysis of whatever stock or company they are investing into. This isn’t the case for traders however, as they are satisfied knowing the short term technical analysis, such as price action and stock charts, unlike investors who perform fundamental and meticulous analysis of the stock.
There you have it, the ancient misunderstanding of trading vs investing has been solved. While investing and trading share the same ultimate goal of profiting from the financial market, their means and strategies of achieving this goal is ultimately different. The mindset and approach of an investor is different from that of a trader, and it takes time and practice to master these approaches. Furthermore, it is very important to properly understand both methods of wealth creation, as if will enable you decide on which one will most likely guarantee you success.