Trading and investing are two approaches to playing the stock market that bring their own benefits and risks
Tradingand investingare two different approaches to the stock market, and which is better depends largely on your time commitment and tolerance for risk.
- Investing involves buying an asset you expect will rise in value over time, with the goal of long-term gains.
- Trading, on the other hand, is about timing market moves and buying and selling stocks within a short period for quick profits.
Actively trading stocks has always been a popular pastime, especially during the long bull market of the 2010s. But during the coronavirus pandemic of 2020, its popularity has reached new heights.
Many traders have become online celebrities. Perhaps you even know someone personally who's jumped on the trading train and you're wondering if you should climb aboard as well — as opposed to just feeding your 401(k) with each paycheck, or investing in the occasional mutual fund.
But it's important to understand that the words "active" and "investor" rarely belong next to each other.
Trading and investing are two different ways of approaching the stock market. With trading, you're hoping to earn quick returns based on short-term fluctuations in the market. Long-term investors, in contrast, tend to build diversified portfolios of assets and stay in them through the ups and downs of the market.
Due to the high-stakes nature of trading and its inherent risks, many investors — especially individuals — may want to avoid it altogether. However, others may want to allocate some of their available funds towards trading and the rest towards long-term investing. Let's take a closer look at the basics of each strategy and their pros and cons.
Investing involves putting money into a financial asset (stocks, bonds, mutual or exchange-traded fund, etc). that you expect will rise in value over time. Investors generally have a long time horizon and predominantly look to build wealth through gradual appreciation and compound interest rather than short-term gains.
The shorter the time horizon, the higher the risk that you could lose money on an investment. That's why the Securities and Exchange Commission (SEC)'s Office of Investor Education and Advocacy recommends putting money in a savings account if you'll need to access it within three years. For all other goals, investing could yield much better returns. Some investors may even plan to hold onto their investments for multiple decades.
Diversification (owning a mix of investments) is important for investors as it can reduce their risk — mainly by mitigating the effects of volatility (rapid, violent, or unexpected changes in values or price). Today, investors can achieve instant diversification through mutual funds and ETFs — single investment vehicles that hold a variety of or a large number of assets. It's also important to consider your risk tolerance and estimated withdrawal date when selecting your portfolio's asset allocation.
If investors do choose individual stocks or bonds, they'll typically look at fundamental indicators — that is, elements intrinsic to the issuing company, like its earnings, history, or creditworthiness. These factors help locate stocks that are undervalued (i.e. value investing) or have a chance to enjoy significant capital appreciation (i.e. growth investing).
Trading involves buying and selling stocks or other securities in a short period of time with the goal of making quick profits. While investors typically measure their time horizon in years, traders think in terms of weeks, days, or even minutes.
Two of the most common forms of trading are
In the world of trading, a stock's fundamentals are fairly irrelevant. Even if a stock's value is expected to go up over the long-term, that doesn't necessarily mean it will do so over the next few minutes, or even days. That's why traders tend to rely more heavily on technical analysis of market movements and news reports to inform their trade decisions.
Trading can be a risky enterprise. If a trade goes against you, you can lose a lot of money in a short period of time. And traders often increase their risk by using leverage — that is, borrowing money or buying assets with money they don't yet have. Options, trading on margin, or short selling are all ways of leveraging.
Famous traders often appear more skilled and knowledgeable than the "little guy" (or gal). And while it's true that some traders are more proficient at reading charts and performing technical analysis than others, no one can accurately predict every trade. Celebrity traders can (and do) lose big on trades too.
If you're interested in trying your hand at trading, taking small position sizes (that is, not spending a big amount) can reduce your risk of losing big on any one trade. Other tips include setting a stop-loss order that will automatically execute if the asset drops below a certain price (thereby limiting your losses).
Is one better than the other?
Although they both involve the financial markets and assets, trading and investing are really two different activities, with different aims. So comparisons and generalizations are tricky.
Overall, though, trading is riskier for two reasons:
- It involves a lot of speculation — that is, quick decisions, educated guesses and just plain gambles.
- It demands minimal (or no) diversification since it's difficult to monitor more than a few trades at the same time. Also, diversification by its "evens-out" nature mitigates both the ups and the downs — and traders want the maximum highs they can get.
However, it should be noted that trading can also mean higher returns. Investors may hope to earn 8% to 10% on their portfolio per year. But a trader may hope to earn that much or more per month. Even traders who earned "just" 5% per month would end up with an uncompounded annual return of 60%.
For these reasons, it's difficult to crown either strategy as the "best" way to approach the stock market. If you have a low risk tolerance and want to avoid volatility, investing will be the way to go. But if you're more of a risk-taker and would like the chance to earn big returns fast, trading could be appealing.
It's important to understand that trading and investing don't necessarily have to be mutually exclusive. For example, you may choose to invest 90% of your money in a diversified portfolio that you'll hold onto for the long haul and earmark the other 10% — your play money, in effect —for short-term, speculative trading.
The financial takeaway
Trading can be a thrilling way to earn quick cash. However, like with gambling, it can also quickly lead to big losses. Investing usually means smaller short-term wins, but also fewer severe losses.
If you're comfortable with the risks, trading with a portion of your money can be enjoyable and could lead to profits. If reducing risk and exposure to volatility are your main goals, then you'll want to stick with long-term investing. But if you're saving for a financial goal that you hope to reach by a specific time, a slow-and-steady investing approach is usually best.
Related Coverage in Investing:
Market capitalization tells you how much a company is worth, and whether buying its stock suits your overall investing strategy
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