Differentiating Between Trading and Investing

John writes:

Hi Chad,

How do you differentiate between “trading” and “investing”? I’m always curious to hear what people think is the difference.

Thanks for the question, John. I don’t think there is too much of a debate over the difference, and my views likely aren’t much different than most, but I’m happy to give my personal thoughts on the topic.

The main difference between “trading” and “investing” is time horizon. Investors are long term players. They are investing in a business and are making an optimistic bet about the fundamentals of that business in the future. If they pay a reasonable price, and their analysis of the business prospects are correct, they will make money over time (regardless of overall market environment) because over the long term both valuation and earnings determine the value of a business, and thus the per share price of a company’s stock.

Furthermore, since investors are willing to take a long term view (years rather than days, weeks, or even months) on an investment, they are likely to buy more shares as a stock drops in price. The main goal is to minimize one’s cost basis in order to maximize profits over time. Temporary drops in share price aren’t likely to change an investor’s opinion of a stock’s long term investment merit, unless of course the fundamental outlook changes in a meaningful way.

Conversely, traders are short term oriented. They tend to care very little about valuation or the long term earnings power of a business. Since they won’t own the stock long enough for future business fundamentals to influence share price, they are more likely to use chart patterns and follow the momentum when buying stocks.

Since traders are more like speculators (making educated guesses as to short term price movements) than investors are, they are likely to use stop loss orders to limit downside risk. If a trade goes against them, they cut their losses quickly and look for other opportunities. Even if the market reaction in the short term is illogical and unsubstantiated, since they aren’t willing to hold the stock long term and wait for the inefficient market to correct itself, they can not afford to wait things out until cooler heads prevail.

Here is an analogy for you; investors are the casinos, whereas traders are the gamblers. Investors have the odds stacked in their favor, just as the casinos are guaranteed winners over time because the games they offer have a win percentage built-in. Over time, the economy grows and corporate earnings grow, hence stock prices rise over long periods of time. Thus, investors (who by definition are long term players) have the odds stacked in their favor.

Traders, on the other hand, are trying to win big on short term trends, much like a blackjack player hopes for a hot shoe and then cashes out his/her chips. The gambler knows that they don’t have a statistical advantage but they play nonetheless, trying to make some money and getting out before they give it all back. Now, I grant you that traders aren’t at a statistical disadvantage, so the comparison isn’t perfect, but whether or not the market goes up or down tomorrow is pretty much a coin flip, so traders’ odds are about 50/50, although they try and boost those numbers with technical analysis, momentum trading, etc. Much like a trader’s stop loss order will limit losses in the market, many gamblers will come to a casino with a certain amount in their wallets, to ensure they don’t incur severe losses.

Casinos and investors know very well that in the short term they might lose money to a hot table or an analyst downgrade, but over time they feel comfortable because they know the odds are in their favor to make money. They are patient enough to wait for their payout, whether it comes from the 5% edge at the roulette table they operate, or long term earnings growth generated by a publicly traded company they have invested in.

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3 Thoughts on “Differentiating Between Trading and Investing

  1. John Forman on March 5, 2008 at 9:28 AM said:

    Just posted my thoughts on your thoughts: The Difference Between Trading and Investing. Shall we start a running cross-blog conversation on the subject? 🙂

  2. mOOm on March 5, 2008 at 6:03 PM said:

    I’d add that derivative traders as a whole are at a statistical disadvantage because the number of longs equals the number of shorts and so therefore the net profit is zero. Take away bid-ask spreads and commissions and they have a net loss. Now some derivative traders are in fact hedgers and aren’t trying to make money but instead mitigate loss – buy insurance. Of the remaining speculators some lack skill and are like roulette gamblers and others have skill and are more like the casino or professional card player.

    In asset trading where there are fewer shorts than longs and positive expected return, there is no reason why the total return couldn’t be split between traders and long-term investors (and firms that issue stock and bonds) in any particular way as almost all investors do in fact trade if only to invest new income in the financial markets.

    So some players in the markets are like gamblers and others like casinos but it doesn’t necessarily break down neatly between traders and investors.

  3. I think I’m late to the party. But, I posted my two-cents (albeit a rather lengthy two cents) on the topic. Trading versus Investing. I think its really interesting to see it from your side as an investor and John’s side as a trader. I, myself, am still working on whether or not I fall in one camp or the other.

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