Many people become rich investing. Many people become rich trading. Many people go broke investing and many go broke trading.
On the surface these two strategies are very similar…the idea is to
buy a financial instrument at a low price and sell it at a higher price
(not necessarily in that order). But when you look deeper into the strategies, the differences are great. So what is
the difference between trading and investing? Most people will answer this question by saying that trading is short-term
and investing is long-term. While this answer is not incorrect, there are other important factors that distinguish the two,
which are essential to understand in order to make money either trading or investing.
Time Frame
One of the key differences between trading and investing is the time frame of the transaction. Traders typically buy and sell
in a short time frame, which could range
from a few seconds to a few weeks or more. An investment, on the other hand, is typically
held for several months to several years or more.
Frequency
The frequency of the transaction is another key difference. Trading usually consists of a large number of transactions, each with
smaller gains. The idea is that many small gains add up to a large profit. An investor looks for large gains with fewer
transactions.
The most important difference between trading and investing is the strategy used for each process. A trader is focused on changes
in the price of the security. The underlying company may be the
best-run company in the world or the worst run company. The price can go up or it can go down…as long as the price of
the stock moves the trader can make money. A trader looks at historical prices with the idea that past prices can be used to
forecast future prices. It is very common to look at trends, moving averages,
volume, or a number of other
technical indicators to help forecast the future movements of the price of the security.
A trader spends most of his time looking at the charts of a security’s price and for the most part ignores
the fundamentals of the underlying company or asset. Figure 1 is an
example of a chart that a trader might use to decide when to buy or sell a security, where the price, volume, and several other
indicators set triggers of when to buy or sell.
An investor is less interested in historical prices and focuses her attention on
the fundamentals of the company or asset. The purpose of an investment is to find a
security that is undervalued by the market and will provide a return of capital gains and income that compensates the investor for the risk taken.
Some of the factors considered for an investment are the financial condition of the company, the quality of the management, the competitive
advantage the company holds in the market, and the potential growth of the security’s price and
dividends.
Making Money
Discipline is the most important quality needed to make money trading or investing. A trader must use discipline to develop and back-test
a unique strategy that has proven to profit in the past, strictly follow the strategy, make sure that downside
risk is minimized in each trade, and ensure that the gains cover the high amount of
commissions paid on the frequent trades. An investor must be disciplined to carry out all due diligence in the research and
valuation of the company, equally minimizing their downside risk. Without discipline, a person who buys and sells a security
is neither an investor nor trader…he is simply a gambler.
Steve holds a BA in Economics and International Studies from the University of Richmond, as well as an MBA with a specialization in
Finance from the University of Miami. He is a Chartered Financial Analyst charterholder, a member of the CFA Society of Orlando, and a member
of the CFA Institute. Visit his web site for more information, or to contact him.