Photo courtesy Mathieu Stern on Unsplash.
People enter the stock markets to earn a return on their investments that is better than the bank’s low F.D. rates or even more than the debt instruments. Bank fixed deposits earn a fixed rate of interest for individuals with not much risk involved. If a person aims to earn higher returns then they have to take certain risks. There is a positive correlation between risk and return. When the risk is higher there are higher chances of a profit or a loss. A low level of risk is associated with low returns and higher uncertainty can provide better returns. A person entering the stock market can either hold stocks for the long term or sell them in a very short period. We will study the difference between trading and investing.
Investing in building wealth over a period of time through holding stocks, mutual funds, cryptocurrency, and other investments. There is a process called compounding where the value of stocks increases. In compounding the interest earned on the investment is reinvested along with the original investment. The invested amount in this way keeps getting larger over a period of time. So compounding is a process of earning interest on interest and the value of investment increases faster than simple interest. When the investments are held for a long period of time over a number of years there are the dividends and stock splits along the way and this increases the value of the stock making the investor richer.
In trading, there are more frequent transactions as compared to investing. Trading can be done with a view for a day, week, or a few days. There may even be multiple trades in a day where an individual buys and sells shares for quick gains. A skilled investor can easily earn 15-18% returns in India over the years while a skilled trader can even earn 20-40% returns in a year. But the catch is that less than 2% of the traders earn money in the stock market. The success ratio is very low in trading. Traders can fall into any of the categories mentioned below-
Scalp Traders-
Scalp traders hold on to their trade for a few seconds to a few minutes. A scalp trader may carry out 10 trades or even 50 trades in a day for a small change in the price of a stock. Their belief is that a small change in stock price is easier to capture than large price moves.
Day Traders-
A day trader buys and sells stocks or currencies on the same day. The position that they create is closed on the same trading day.
Swing Trader-
A swing trader participates in a trade that is held for one or more days and tries to profit from the price swings. The holding period is longer than a day trade.
Position Trader-
The positional trader holds stocks for a longer period of time that is months or even years while the swing trader holds stocks for a few days. The comparison between investing and trading is as given below-
Holding Period-
The traders hold stock for a short period of time could be from a day to a few weeks while investing works on the buy and hold principle. Investors can hold on to stock from a few years to even decades to get multi-bagger gains.
Risk-
Trading is riskier than investing. Both trading as well as investing carry a certain amount of risk but trading is certainly riskier than investing. If a person is good at stock picking and can pick quality stocks then he can invest for a long period of time and benefit from the power of compounding as well as from dividends and stock splits. A trader doesn’t have to worry much about the quality of stock as he would be holding the stock for a short period of time.
Timing the market-
It is very important for traders to be aware of short-term trends. They should be aware of technical analysis and the knowledge of the charts also helps. The buy-and-hold investor does not have to worry about the short-term price fluctuations to make a profit. They do the fundamental analysis of the stock and try to make big gains over a longer time horizon.
Diversification-
Diversification of a stock portfolio is important in investing. Since an investor plans to hold the shares for a year to a few years some of the sectors may not perform well during certain economic conditions. It is necessary for investors to diversify across sectors and stocks of different companies and industries. This way you can cut on the unsystematic risk of a company or sector not performing well. In trading, there is not much need to worry about diversification and a person has to only worry about trends in the market.
Taxes-
When an individual holds the stocks for a year or more it is taxed as long-term capital gains or loss and for a frequent trader when the stocks are held for less than a year it comes under short-term capital gains or loss.
Decision Making-
Individuals involved in scalp trading or day trading have to make quick decisions sometimes even in split seconds as they wish to gain in the short term. The investing decision can be taken over a longer period of time after studying the fundamentals and management of the company.
Liquidity-
Investing is generally done with the purpose of holding stocks over a longer-term but trading is generally done with a short-term time horizon. If you are in need of funds you can cut short your positions to meet your liquidity requirements but in investing since you have planned for holding funds for a longer time horizon it may be difficult to reverse your original decision.
Investing as a strategy works better for most people. It is fairly easy to be an investor than a trader. Trading requires market timing skills and a few people emerge as successful traders. Individuals who can’t devote much time daily and want to develop a passive source of income can invest their money to grow their capital and persons who are able to time the market should go for trading and start with a small amount, to begin with.