Investing Vs Trading What S The Difference
There is a question that is occasionally asked by newcomers to the financial markets and even debated by experienced participants. The question is how to tell the difference between trading and investing. Because trading and investing are performed in very similar ways when viewed through the lens of the financial markets, they are frequently regarded as interchangeable actions.
In my book, The Essentials of Trading, I expanded on this basic theme by proposing that what distinguishes the two is scope definition. After all, both trading and investing are, at their most basic, the application of capital in the pursuit of profits. If I buy XYZ stock, I expect the price to rise or I will receive dividends – or both. What distinguishes trading from investing, however, is that in trading, one generally has an exit expectation. This could be in the form of a price target or the length of time the position will be held. In either case, the trade is thought to have a limited lifespan. Investing, on the other hand, has a wider range of possibilities.An investor will buy a company's stock with no idea when, if ever, he or she will sell it.
We can use examples to demonstrate the distinction. Warren Buffet is a businessman and philanthropist. He buys companies that he believes are undervalued and holds them for as long as he believes in their prospects. He does not consider the price at which he will sell the stock. George Soros is a trader (or was when he was still actively running his hedge fund). His most famous trade was shorting the British Pound when he believed it was overvalued and about to be removed from the European Exchange Rate Mechanism. He took the position he did because of a specific circumstance. Once the pound was free to float, it quickly devalued in the market.Soros walked away with a tidy profit. That satisfies the requirement of having a predetermined exit, making it a trade rather than an investment.
However, there is another way to define trading as opposed to investing. It has to do with how the applied capital is expected to generate a return. The goal of trading is to increase one's capital. You purchase XZY stock at 10 with the expectation that it will rise to 15 and generate a capital gain. If dividends or interest are paid out along the way, that is fine, but it is likely that they will only make a minor contribution to the expected profits.
Investing, on the other hand, is more concerned with long-term income. As a result, income generation, such as dividends and bond interest payments, becomes the primary focus. Do investors benefit from capital appreciation? True, but, unlike in trading, this is not the primary motivation.
Keeping these definitions in mind, consider what many people consider to be their single largest investment – their home. However, according to our second definition of investing, a home is generally not an investment because it does not generate any income in most cases. In fact, it generates significant expenses in the form of mortgage interest payments, utility bills, and maintenance. A house is, if anything, a trade. We purchase it in the hope that its value will rise over time, increasing our equity. And the fact that many people expect to move in a few years and sell makes it even less of an investment and more of a trade. (Of course, owning a rental property can be considered an investment., unless one is flipping it, which is unquestionably more trading.
As previously stated, for many people, trading and investing appear to be the same thing. The mechanics of buying and selling are nearly identical. Sometimes the analysis used to make those decisions is the same. However, the intention and definition of objectives are what distinguishes trading from investing.