When I started to learn about the financial markets, I came across these terms – Investing and Trading, and always thought that they mean the same thing which is to make profits from the financial markets. Fortunately, somebody pointed out my misconception and showed me the distinct differences between them. So how different is investing compared to trading?
People who adopt investing as their approach are known as investors. This method requires them to buy and hold a portfolio over a long period of time, roughly about a few years or even decades. The objective is to use the power of compounding to accumulate wealth and use diversification to lower the risk of the portfolio. Investors mainly aim to profit from dividends rather than capital gains.
The portfolio usually consists of financial instruments belonging to the middle or lower risk class such as stocks, bonds or cash equivalents. A general guideline of a well-diversified portfolio is one which has a mix of about 30 kinds of stocks, bonds or cash equivalents in different sectors. Investors tend to use more of fundamental analysis to analyse whether an instrument is worth investing in.
People who adopt trading as their approach are known as traders. The time horizon for trading is significantly shorter than investing, which range from seconds to a few months. Traders do not buy and hold portfolios; they seek capital gains by finding chart patterns and predicting the future price trends of an instrument from historical prices, either by buying or shorting it within the short time frame.
Traders usually use leveraging to multiply their potential profits. While this may sound like a good idea, leveraging is a double edged sword which also increases the potential losses at the same time. Hence, most traders use a protective stop to close losing positions at a predetermined price level to limit their losses. The selected financial instruments needs to be highly volatile in order for traders to trade effectively, thus financial instruments in the high and middle risk class, such as derivatives and stocks, are often traded by the traders. Technical analysis is the more preferred analysis method by traders to determine whether an instrument has good trading potential.
Both investing and trading are methods used to make potential profits from the financial markets. However, they are “same same but different” and these are what set them apart:
- Time Horizon
- Strategies applied
- Financial Instruments used
As the saying goes – high risks high returns, low risks low returns. Though trading has the potential to give high returns within a short period of time, there is a significant amount of risk involved which may not be suitable for everybody. Investing, on the other hand, has relatively low risks but requires a significant amount of time to accumulate returns. To know which method is suitable for you, it is important to educate yourself about the pros and cons before making a decision.