Oran Hall | Trading versus investing
QUESTION: What is the difference between trading and investing? What do you call trading a security as opposed to investing in a company's stock? Is it based on time?
FINANCIAL ADVISER: Investing is using money to make more money by gaining income, increasing capital, or both. It is considered to be long term in nature. On the other hand, trading is buying and selling investment instruments frequently with the objective of short-term profit.
Some investment instruments are short term by nature. These are primarily income-producing instruments and are useful for income, liquidity, and security of principal. Some instruments like equities and bonds are long term in nature. They are the instruments that facilitate trading, but it is important to note that both types are needed in a diversified portfolio.
So, is it better to trade or to invest? In a sense, trading can be beneficial as it may make short-term returns more certain, but it is not always as profitable as it appears, particularly when you consider your net returns and not your gross returns.
This is not to say that you are not to take profit. It is better to do so with a portion of the portfolio than to sit by and watch your gains evaporate when the market declines.
The trading approach requires regular monitoring of the market to find new opportunities and to make decisions regarding when to buy and sell. This approach puts much emphasis on market timing, but you will not always get it right although, depending on market conditions, good profits can be made by trading. There is, nonetheless, the risk of selling too early and the erosion of profits by the fees associated with buying and selling stock frequently.
The long-term, or buy-and-hold, approach is a better approach than the trading approach. Its focus is time in the market rather than market timing. Time in the market does not mean holding an investment instrument for a lifetime. It means holding it for years: three, five or longer - depending on your goals and circumstances.
Transaction costs are generally lower using this approach than the trading approach because of the lower level of trading. Therefore, trading expenses tend not to erode profits as much. The long-term approach also facilitates passive investing.
If you know why you are investing and take a long-term view, you will see little need to trade aggressively. This long-term approach can reap significant gains for investors in equities and other investments that yield capital gains. Periods of decline in the markets may be seen as opportunities to invest at lower cost, thus reducing the average cost of the portfolio. Even long periods of decline eventually end so you can realise very good returns, but it may take time.
We see this happen in our stock market from time to time and note the handsome rewards faithful investors - but also some traders - reap when the market rebounds.
Taking a long-term posture does not mean that there should be no liquidation of positions. You should always have an exit strategy. It could take either or both of the following: determine for how long you want to hold your investment or set a rate of return that you will be satisfied with.
It also makes sense to exit a position if a particular investment is no longer a good fit for the portfolio or does not seem to have good prospects for the future. It is reasonable to expect that the time will come when the initial reason for making the investment has come, thus triggering a decision to sell. Taking these approaches reduces the risks of not exiting a bad position and not taking profit.
Dollar cost averaging is one means to obviate the need to determine the right time to buy and sell. You do not have to dive into the market and invest all at one time. There is wisdom in investing systematically - a set amount regularly such as in dollar cost averaging. This way, you get some stocks at low prices, some at high prices and others in between.
Trading and investing are quite different in how they achieve the making of money. These differences are evident in how much time elapses between purchase and sale, the trading expenses incurred, the realisation of short-term gain and, ultimately, net returns in the long term.
- Oran A. Hall, the principal author of 'The Handbook of Personal Financial Planning', offers personal financial planning advice and counsel. firstname.lastname@example.org