The Difference Between Trading and Investing
The longest bull market in history lasted from March 2009 to March 2020.(1) When it ended at the beginning of the pandemic, we then saw the shortest bear market ever, ending just 33 days after the S&P 500 dropped more than 30%.(2) Investors were already primed to think that the rising tide of a bull market lifts all boats, and that it no longer mattered who was swimming naked, as the famous quote from Warren Buffet goes. Over the last year things have gotten even more exciting, as bored day traders made GameStop temporarily a thing, and not only bitcoin but dogecoin had a run. These aberrations can cause risky investing behavior to appear more prudent than it actually is.
So let's take a step back and understand the differences between investing and trading and the place each of these styles has in an investment strategy.
The Characteristics of Trading
The key thing to remember when differentiating between trading and investing is the goal of the action. When trading, the goal typically isn’t to hold a stock for years and benefit from appreciation. Rather traders seek out short-term gains and aim to take advantage of quick drops and spikes in prices.
There are different styles of trading such as day trading, where positions are typically only held for a day at a time. Then there are also longer-term styles, such as swing or position traders, where they may hold investments for a few weeks to years. Trading requires just as much research and knowledge as investing – it’s just deployed somewhat differently. Traders are trying to understand and predict where a stock’s price will be at a given point. To do this, they often use technical analysis, such as price history, to look for trends in the market. Since prices are constantly changing, depending on the type of trader, they must act quickly to scoop up potential profits.
For assets such as cryptocurrencies, they are often considered trades because, even if the intention is to hold them over a long period, they are so speculative that the risk puts them into riskier trading categories.
How Is Investing Different?
Investors tend to take a long-term approach to the market. Rather than trying to capitalize on very short-term opportunities, investors are buying stocks or funds whose fundamentals they have researched thoroughly. They create an asset allocation, and then select investments that may follow a ‘buy and hold’ strategy that will be appropriate for a place in a long-term asset allocation. Investing aims to create wealth over many years through the power of compound interest and long-term growth of the market.
When taking a long-term approach, day-to-day fluctuations in the market don’t have as much of an impact as they do when trading. The reason is that depending on an investor’s time horizon, it may be years or even decades before the price of the investment appreciates to the top of the projected range. Not to say that investors don’t cut their losses, because that’s an important part of investing, too.
Deciding Which Strategy to Follow
When deciding whether to trade or invest, it’s important to first know the goals for wanting to put money in the market. Is the goal to save for retirement or other long-term goals? To try and turn a quick profit? Knowing the end goal will help determine which approach is right.
It’s also important to take tax consequences into consideration. When taking a short-term trading approach, short-term capital gains come into play. Short-term capital gains are taxed as ordinary income while long-term capital gains are taxed at a much more favorable rate, currently capped at 20%.(3)
It can be easy to get caught up in the buzz around the latest hot stocks. However, frothy markets come and go – and sometimes very quickly. As we saw last year, long-term investments recovered. Short term trading strategies that were caught in the market’s precipitous decline and then rapid bounce back weren’t so lucky.
The Bottom Line
While there’s increased risk any time money is put into the market, it’s important to determine investment goals and purpose, as well as risk tolerance. There may be a place for a small amount of speculative investments or trading strategies in an investment portfolio – and a booming market is good time to try that out – but it’s important to be very careful that a short-term strategy won’t derail long-term goals.
1. Wigglesworth, Robin. US Stocks’ Record Bull Run Brought To Abrupt End By Coronavirus. Financial Times. March 12, 2021.
2. Jason, Julie. The Coronavirus Stock Market: A Market Gone Wild. Forbes. April 8, 2021.
3. Ashford, Kate. What Is The Capital Gains Tax Rate? Forbes Advisor. February 12, 2021.
Pamela Chen is the Founder and Chief Investment Officer of Refresh Investments LLC, a fee-only financial planning and investment management firm located in Santa Monica, CA serving clients throughout the great Los Angeles area and the United States.
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