There is a question which is often asked by those new to the financial markets, and hotly debated by experienced financial market participants keen to sit in one camp or the other – what is the difference between trading vs investing?
Well, they’re both actioned in a similar fashion and are often thought of as interchangeable actions.
So what’s the answer?
It’s a question of scope
In my book, The Essentials of Trading, I followed along with this basic theme by introducing the idea that what differentiates trading vs investing is the scope, rather than the objective.
Both trading and investing, at the most basic of levels, require the application of capital in the pursuit of profits. If I buy XYZ stock, I expect to either see the price appreciate or earn dividends – perhaps both. What separates trading from investing, however, is that generally in trading there is an exit expectation.
This might be in the form of a price target – or in terms of how long the position will be held. Either way, the trade is seen to have a finite life. Investing, on the other hand, is more open-ended. An investor will buy a company’s stock with no predefined notion of when that stock will be sold, if ever.
We can use examples to help demonstrate the difference between trading vs investing.
Warren Buffet is an investor. He buys companies which he sees as somehow undervalued and holds on to his positions for as long as he continues to like their prospects. He does not think in terms of a price at which he will exit the stock.
George Soros is a trader (or at least was – while he was still actively running his hedge fund). His most famous trade was shorting the British Pound when he thought the currency was overvalued and ready to be withdrawn from the European Exchange Rate Mechanism. The position he took was based on a specific circumstance. Once the Pound was allowed to float freely, it quickly devalued in the market. Soros exited with a substantial profit. That meets the criteria of having a predefined exit – making it a trade, not an investment.
The application of capital
There is another way to define trading vs investing.
It has to do with the manner in which the applied capital is expected to produce a return. With trading, the appreciation of capital is the objective. You buy XYZ stock at $10, expecting it to go to $15 – producing a capital gain. If dividends or interest are paid out along the way, great, it’s likely to be a minor contribution to the expected profits.
By contrast, investing looks more toward income over time. That makes income production, like dividends and bond interest payments, the major focal point. Do investors experience capital appreciation? Sure, but unlike in trading, that is not the primary motivation.
With these definitions in mind, consider what many people refer to as their single biggest investment – their home.
Based our second definition of investing, a home doesn’t really fall into the investment category because, in most cases is does not produce any income. In fact, it produces considerable expenses in the form of mortgage interest payments, utility bills, and upkeep.
If anything, a home is a trade. We buy it and hope for its value to rise over time, increasing our equity.
Owning rental property fits in more comfortably with our definition of an investment. The income derived would be expected to more than cover the cost of outgoings related to the property while the value of the property rises over time.
So, what’s the difference between trading vs investing?
Many people see trading and investing as the same thing. The mechanics of buying and selling are basically the same. Sometimes the analysis done to make those decisions is identical as well.
However, it’s the intention and definition of objectives which separate trading and investing.
This post has been reproduced from John’s blog which you can find here