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The difference between Trading and Investing

Posted by: Garth Mackenzie Posted on: 2014-01-13


In my work as someone providing trading guidance, I regularly see people facing difficulty in identifying the difference between trading and investing. The two disciplines are very different, but there are overlaps and it is very easy to muddy the waters between the two approaches. 

 

Too often I see people trying to apply an investment approach to short term trades, and likewise, I see people getting too caught up in short term volatility and trying to apply a trading approach to their long term investments. This usually results in unfavourable consequences. 

 

For this reason, I feel it is necessary to explain the differences between the two disciplines. 

 

I’ll start with investing, and specifically stock market investing. This refers to a long term endeavour to grow your capital. By long term I am talking 5 to 10 years or even longer. It is a relatively passive approach to capital growth.  

 

Investing involves buying into the underlying shares of companies with a long term view. You’ll buy these shares because you like the company’s future prospects, the management and the industry that the company operates in. You will look for gradual capital growth as well as income generation from the shares in the form of dividends. The dividends can then be re-invested back into the market to assist in achieving a compounded return on the overall investment.  

 

You’ll look to hold these shares through periods of short term volatility and keep your sights on the longer term goal of capital growth. Market timing is less important when investing. The saying is that it is “time in the market” that counts when investing, rather than “timing the market”. 

 

This is a relatively passive approach to capital growth and does not involve active buying and selling of shares on a regular basis. It is more of a “buy and hold” strategy. 

 

The tools that you will typically use to do your investment analysis will revolve around fundamental analysis. You’ll look at things like earnings growth rates, Price / Earnings ratios, dividend yields and any future business expansion plans. If your analysis is done correctly, these fundamentals ultimately win in the long term and will be reflected in the long term performance of shares. 

 

The gains on your investments (when you bank a profit) are generally taxed as capital gains which are taxed at your relevant CGT rate. (As a rough rule of thumb, the South African Revenue Service will generally treat any investment that is held for more than 3 years as a capital gain, with some exceptions). You will also incur dividend with-holding tax on the dividends you receive in your personal capacity.  

 

 

Trading on the other hand requires a very different approach and is a far more short term endeavour. One requires active initiative and one needs to time the market far more precisely. In trading, it is all about “timing the market” rather than “time in the market”.  

 

In trading you can trade in both directions, long and short. Long meaning that you anticipate prices rising and you buy with the intention of selling at a higher price. Short meaning that you sell first, anticipating that prices will fall, and then you buy back at a lower price later on (yes this is legal and is a common trading practise). 

 

Trading involves trying to capture short term movements in the market with limited risk. The time frames for these movements can be anything from a few seconds to a few months. Very active traders can buy and sell several times per day (intra-day traders) and less active traders might buy and sell only every few weeks or every few months. The frequency of trades will depend on the individual. Ideally, traders should find a style of trading that suits their personality. Some people thrive on the excitement of regular intra-day trading, while others (like myself) prefer to take a slightly longer term view and hold trades for a few days to a few weeks at a time. 

 

The tools that one typically uses for trading are different to investing. First of all, the products usually differ. Derivative instruments such as Contracts for Difference (CFDs) or Futures are more suitable for short term trading. The reasons they are more suitable are that the transaction costs are typically much lower than when buying and selling underlying shares, and these derivative products allow you to leverage your capital (take a larger exposure to the market than your capital would allow with ordinary shares). Note that derivative instruments have daily interest costs associated with them that can make them more expensive to transact in than underlying shares if you hold for lengthy time periods. But if you’re holding for a relatively short period of time these interest costs become negligible.  

 

Your analysis tools for trading when compared to investing also differ. You will generally make far more use of technical analysis in order identify short term market dynamics. In the short term, market movements are determined by sentiment, and as a trader you will try to identify which way this sentiment is moving and you will look to capture the consequent movement that sentiment causes. Often the short term sentiment may be in total conflict with what the long term fundamentals may indicate, and these are the opportunities that traders look to capitalise on. 

 

Market sentiment is best measured using technical analysis (analysing charts). At the end of the day, a chart is simply a graphic reflection of the dynamic between buyers and sellers.  Ultimately it is this dynamic that determines price movement. If buyers exert stronger force than sellers, then prices move higher. If sellers exert more force than buyers, prices move lower. It all comes down to the collective psychology of all buyers and sellers in the market. Technical analysis is the best tool to use to measure this psychology and hence why it is an important tool for short term traders to use. A number of patterns tend to repeat themselves in charts over time, and these patterns can provide profitable trading opportunities provided they are combined with a disciplined approach to risk management. 

 

Risk management is also a vital element to successful trading. Trading is essentially a game of playing the probabilities. You look for trade opportunities that have a higher probability of working than just 50/50. These types of trades can be identified with a good understanding of technical and fundamental analysis. But even trades that may appear to have a very high probability of success can go wrong, and for this reason, a trader needs to ensure that he knows what his risk is when entering a trade. This implies knowing what the worst case scenario may be in terms of loss if a trade does not work out.  

 

That worst case scenario should be determined by where a trader sets a stop loss. A stop loss is (as the name suggests) a point at which the losses will stop being incurred and a trade will be closed out. Traders need to exercise discipline when it comes to executing stop losses. Trading requires keeping losses small, and maximising profits. We refer to this as a risk to reward ratio. 

 

The risk to reward ratio needs to be favourable on every trade that a trader enters. What this means is that the amount of potential profit that could be made on a trade should be significantly greater than what the potential loss may be. Ideally, the potential reward should be at least 2 times greater than the potential risk (the higher the better, but 1 : 2 is a minimum acceptable risk to reward ratio as a trader).  

 

This risk to reward ratio needs to also be combined with a favourable hit rate on all trades. The hit rate refers to the number of winning trades versus the number of losing trades. Obviously you’ll want more winners than losers.  

 

As trading is a far more active endeavour than investing, it also means that there is no emotional attachment to the shares you trade. The shares you trade are either working for you, or they’re not. If they’re not, you should close the trade and move on.  

 

I often refer to investing being a lot like the marriage game, whereas trading is more like the dating game.  

 

I have mentioned the word “discipline” a few times when discussing trading. This is probably the most important word in trading. Discipline is vital in all aspects of trading, including correct position sizing, executing stop losses, knowing when to hold and knowing when to close a trade. To this end, the words of Kenny Rogers when referring to the game of poker in his song The Gambler are very apt for trading: “You gotta know when to hold ‘em, know when to fold ‘em, know when to walk away, and know when to run”. I am never a fan of referring to trading as gambling, but there certainly are some similarities. 

 

To me, trading is less random than gambling and can be a more consistently profitable endeavour if you know how to trade well. 

 

When it comes to tax, trading profits are treated as income and they are therefore taxed at your marginal rate of income tax.  

 

 

In my own personal financial management, I have roughly 90% of my investable assets in long term investments, and 10% in a trading account. I view my trading portfolio as an asset class of its own within the overall asset make-up.  

 

With my longer term investments, I am looking to try and achieve a total compounded annual return (incl dividends) of between 10% - 15%. If you can consistently achieve a compounded return of 15% per annum, your money doubles every five years. I’ll be happy with that. 

 

The interesting thing regarding the 10% - 15% annual return I aim to achieve with my long term investments is that this can generally be achieved with rather boring, steady companies. You don’t necessarily need to try and find the next Microsoft, Google or Apple. Too often I see people trying to invest in the “next big thing” only to be disappointed the majority of the time. A safe, steady approach of investing into tried and tested companies that have a long history of churning out consistent returns can often yield better long term returns than trying to find the next big thing. 

 

In my trading account, I aim to achieve a total return of 4% per month. Some months I achieve that and some months I don’t. Some months I do better than 4%. But on the whole, I try to achieve an average compounded return of 4% per month. 

 

Generally it requires taking on greater risk to achieve this type of trading return, but I also understand how to manage the risks appropriately so that they don’t spiral out of control. 

 

It is vitally important that you understand the differences between trading and investing and know whether you are a trader or an investor. The points above should help you to identify which camp you fall into. Note that you can fall into both camps, but if you do, understand that the two disciplines need to be separated and treated differently.

 

By Garth Mackenzie (Founder and Editor of Traders Corner)

 




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Reply to this post 1 izzy Great article and very well explained. 

Reply to this post 2 Ashley Well explained indeed, so does trading currencies require the same discipline as trading in shares? 

Reply to this post 3 Garth Mackenzie Yes, you need to apply the same level of discipline to all trading, irrespective of what product you are trading. 

Reply to this post 4 Zander Very informative and helpful.  




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