What is the difference between trading and investing, and is one better for you?
Trading vs. Investing
Let's start by breaking down each one.
In the world of investing, trading is the act of buying and subsequently selling securities in a short period of time in the hopes of making a quick profit. "Short" is a relative term for the time period that can range from seconds to months, but regardless the intent is to sell the security, not to hold it.
Trading often utilizes the stop order. Stop orders, in trading, dictates the price at which you are willing to buy or sell. This can mean a stop-limit order, where you set both a price that would trigger an order and a limit on the amount you will use to buy, or a stop-loss order, which dictates the price that triggers an order to sell. These are designed both to help you buy securities at a reasonable price and help you sell them before incurring major losses (though neither of these are guaranteed).
Trading stock involves a lot of moving pieces, and at times more of a pressing need for the trade to be a profitable one. After all, as a trader you are constantly putting new money into new securities to sell later.
The hope and expectation among many traders is to get a monthly return of 10%. So if you started with $50,000 in your brokerage account for trading, your goal is to have $55,000 in it next month as a result of your trading. Then $60,500 the second month. By the end of that year, a return of 10% monthly would turn that $50,000 into approximately $156,921.42.
Though that's if you meet your goal; depending on how well you trade throughout the month, you could end up significantly lower or higher than 10% returns.
The most commonly known form of trader in the stock market is likely the day trader, the person who does a high volume of trading during market hours, buying securities and selling them by the close of the market in the hopes of finishing the day with a positive return.
However, there are other types of traders who are categorized by the length of time they hold onto their securities before selling them off. Scalp traders, for example, hold on to securities for as little as a few seconds and not longer than mere minutes. Scalp traders, like day traders, don't hold positions on any securities overnight.
Swing traders, on the other hand, can hold overnight positions. That's because they use a more longform approach to trading, holding these positions for days or weeks before selling.
While trading is itself a form of investing, it is separate from long-term investing, the process of buying shares and holding onto them as they increase or decrease in value. Here, you are acting as an actual investor in a company instead of someone briefly owning some of its shares.
Investing means putting in time, possibly even decades if an investment is going well enough, before selling it. As opposed to trying to determine the minutiae of what can happen in the market during mere minutes, you'll need a long-term outlook. How has this company performed on a year-to-year basis, and is there cause to believe the positives you saw will continue?
This requires a lot of patience. The market is inherently volatile and risky, so long-term investing involves riding out some downturns in the hopes that it will rebound.
You may already technically be investing; if your job offers a 401(k) or an IRA and you are using it, those are long-term investments.
Differences Between Trading vs. Investing
Some of the differences are self-explanatory. Trading requires constant buying and selling, while an investor's portfolio is filled with long-term securities. A trader sells high while an investor holds on through the various fluctuations of the market.
Here are some of the other ways these two can differ.
Trading may seem like a way to get more money in the immediate future, but you'll have to consider the capital gains tax. The capital gains tax is applied to any capital gain, and trading involves a lot of buying and selling.
That's a lot of different gains that are being taxed in a given year if you're an active trader, compared to one making passive income on long-term investments.
Short-term capital gains and long-term capital gains (the latter applies to assets owned for at least one year) are taxed differently. A short-term capital gain is taxed at a standard rate based on what your income bracket is when filing, which is not true of long-term gains.
In fact, depending on your taxable income, your long-term capital gains could be taxed at a rate as low as zero. Even the highest rate long-term capital gains can be taxed at is 20%, much lower than the highest income tax bracket.
The actual capital gains getting taxed can also differ by whether you're trading or investing. With trading, your gain is just the return you're getting from the various trades.
With a long-term investment, though, you may end up with other capital gains to go along with the stock. Many companies offer dividends to their shareholders, on a quarterly or annual basis.
Long-term investments can also have gains unique to those in trading based on how a company operates over an extended period. A company may also, depending on how well it's doing, decide to do a stock split that can potentially increase the stock price.
A long-term investment can also have compounding interest on it, adding more to your gains.
With trading, you will need to stick with securities that can liquidate quickly. So while other securities can be traded, many stick primarily with stocks.
An investment portfolio that is focused on long-term gains has the opportunity to be much more diverse. Stocks, bonds, mutual funds and ETFs are all common choices. But you can also diversify it with other assets that can increase in value, such as real estate. Of course, securities like these are much harder to liquidate, and that should be taken into account if you're an investor who wants that.
Whether investing or trading, there's a good chance that you'll be using a brokerage account. A brokerage will help to streamline a lot of the moving parts that go on with trading, like the stop-limit and stop-loss orders. But this will come with costs that differ based on which one you're doing.
Brokerages have commission costs that will cut into the return, and the commission varies from broker to broker. You'll have to keep the commission in mind when determining what an acceptable return will be, as a return that might look good on paper gets less profitable when the broker gets their cut. And if you're trading dozens, if not hundreds of stocks a day, that's a lot of commissions you'll be paying.
Of course, risk is just the norm with all forms of investing. But different types of risk impact trading and long-term investing differently. The volatility of the stock market means that if something causes a drop-off for mere minutes, the unlucky trader holding onto that company's shares can find themselves at a loss. If something causes the market to fall significantly on one day before rebounding the next, someone who has been holding onto their shares for years will ride out the downturn and see it rise the next day. But on a bad day for the market, a trader making a mistake can lose quite a bit, impacting their daily, monthly and yearly returns.
Of course, trading can also be a good way to try and mitigate the risk of the market collapsing entirely and the economy going into a recession, as you're not trying to hold anything for an extended period of time. But a recession could crater the value of a long-term investment.
The luckiest of the lucky investors might do well enough to make their living off investing. Make the right long-term investments, and you'll barely have to do any work at all to make your money. Keep the occasional tabs on it, and stay aware of how the company is doing and how the market has been performing.
Day trading is more of a time commitment. You'll need to spend a fair amount of time researching many different companies, deciding whether to make the investment, and staying constantly up-to-date on your brokerage account to see how the returns of your various trades turned out. It can be a lot of work for some investors, but others feel they thrive off the environment.
Is One More Profitable Than the Other?
Trading and investing are both viable and common ways to try and profit from the stock market. But is one more likely to get you a larger return?
Not really. Both can bring in huge returns or blow up in your face. Trading may seem like a way to get higher returns in the moment, but that's never a guarantee. You're aiming for a 10% return each month, but a bad day or multiple bad days can put you at a loss. With a serious enough loss, you may not only have lost a lot of your money, but be required to put more of your own capital into your account to maintain the minimum balance. Stock trading brings a lot more risk and requires a lot of knowledge of the market and the ability to make quick decision making.
Long-term investing, though, is also no guarantee at any eventual success. You're going to need to do quite a bit of research to make sure you're making the best possible decision for yourself about the company in which you're going to spend years investing. It's likely to grow at a slower rate than the ideal trading account would, but over a longer period of time.
Ultimately, the best thing for you when deciding which to pursue is not to consider which one will bring greater returns. Both bring potential and both bring risks. Find the one you're most comfortable doing and have the best means to do, and do as much research and preparation as you can.
This article originally appeared on thestreet.