Due to rising inflation and looming interest rate hike, the stock market has been extremely volatile since late 2021. With the commodity prices continuing to surge fuelled by the current political situation between Russia and Ukraine, market volatility is likely to continue.
This is an extremely tough period for the retail investors, whose stock portfolio balances continue to evaporate as the overall market continues to go down. Some retail investors even go to extremes and turn into traders. One of the more well known examples of this transition is Kevin Paffrath (aka Meet Kevin), a long-term investing and dollar cost averaging advocate on Youtube with 1.8M subscribers. He sold almost his entire $20M stock investment portfolio and became a market-timing trader in early 2022.
Just how different is investing versus trading stocks, and which one is better? Let’s have a look at some of the key differences, pros and cons of each, see which one might be more suitable for you.
Main differences between Investing and trading
Although both investing and trading stocks involve buying and selling, these are some key differences between the two.
Mentality
Stock investors buy stocks as a way to own small parts of the underlying businesses they see valuable and future growth potential. They want to buy stocks at a reasonable price based on fundamental analysis, expecting stock prices to go up over time as these businesses grow, in turn growing wealth.
Traders on the other hand buy and sell stocks hoping to profit from the price differences. They look at both fundamental and technical analysis to identify entry and exit signals, focusing on cash flow (income) generation.
Time frame
Investors tend to hold stocks for a longer period of time (typically years), as they usually have a long term outlook, allowing time for the companies they believe in to grow. Traders usually have a much shorter time horizon, from several weeks, days, to several minutes, or even seconds.
Risk and reward
Both trading and investing involve risk taking. Given the stock prices are more volatile in a shorter time frame, trading has more short-term risk and return potential.
Investors on the other hand tend to hold their stock investments over a much longer period of time. As long as they picked the right businesses to invest in, short-term stock price fluctuation won’t impact the long term growth trajectory of these businesses. This lowers the short-term risk and reward of investing, which could deliver higher long-term returns.
Advantages of investing
Wealth building
When it comes to stock investing, “Our favorite holding period is forever”, based on the living legend Warren Buffett. For most individual investors, buying fairly valued stocks from good companies or index funds and holding them for a long period of time is one of the best ways to build wealth.
Despite the short-term market volatility, stocks issued by great companies with solid growth and business fundamentals almost always go up in value over a longer period of time.
Low barrier to entry
For beginner investors who find it difficult picking individual stocks, the easiest way to invest in the stock market is to buy and hold index funds. An index fund is basically a stock portfolio with positions mirroring a stock index and is managed by the professionals. All you need is to invest your capital, and let the qualified pros do the work.
A good example would be the SPDR S&P 500 ETF (ticker symbol SPY), an exchange traded fund mimicking the overall performance of the S&P 500 index. It’s easily accessible from most brokers just like individual stocks. If you invested in SPY 10 years ago and never sold, you would have tripled your investment.
Passive income generation
One of the best things about investing in the stock market is the ability to generate passive income through dividends. A dividend is the distribution of a part of a company’s earnings back to its shareholders.
Owning a portfolio of high dividend-paying stocks from consistently profitable companies is the best way to get paid regularly, without any active work required. It’s ideal for those who want to achieve financial freedom or retirement.
Disadvantages of investing
Patience
In most cases, investing in stocks requires patience and a longer time horizon. As stock prices go up and down in a shorter time frame, there is no guarantee the stocks you just bought will go up immediately.
Most of the best stock investment returns are realized over years or even decades of holding period. The key is to buy fairly valued stocks from great companies, and give them enough time to grow and compound.
Emotional rollercoaster
The stock market can be volatile, with stock prices swing up and down second by second. Seeing the portfolio balance goes up and down can be emotionally draining. Many beginner investors make the mistake of buying high and selling low, out of greed and fear.
The best thing to do for the long term investors is to not constantly check their stock portfolio. As long as you keep tabs on the companies you invested in, and as long as the business fundamentals remain intact, there is no need to actively micromanage your stock portfolio.
Advantages of trading
Income generation
Stock trading is risky, and most beginner traders lose money. But for the traders who manage to become consistently profitable, trading can be one of the best jobs to generate income.
There are plenty of traders who are consistently profitable. Day trader Ross Cameron, founder of Warrior Trading, turned $583 into $1M in just 2.5 years, from Jan 2017 to May 2019. It’s almost like having the superpower of money printing.
Freedom
All you need to start stock trading is yourself, the internet, and computer equipment. Once you master the art of trading and become consistently profitable, you can literally make money anywhere you go, without relying on anyone else. No more corporate rat race, you generate income on your own terms.
More opportunities
Unlike investment where the capital is locked behind the investment for a longer period of time, once you close a stock trade, the initial fund (plus profit or minus loss) is freed up and can be immediately redeployed to another trade. For a consistently profitable trader, this presents an almost unlimited amount of opportunities to make money.
Disadvantages of trading
High barrier to entry
Stock trading is difficult. No one can predict where stock prices will go in the short term. What traders can do is to position themselves in high probability trades to make money, through technical and/or fundamental analysis, timely execution, together with a lot of risk management. These skills may require years to develop and master.
Risk
Trading is risky. Failing to manage risk is one of the biggest reasons why most beginner traders lose money. Without proper risk management, it’s not uncommon for beginner traders to blow out their accounts and quit trading altogether, without allowing enough time to develop their skills.
Conclusion
Investing and trading each has its advantages and disadvantages. Many traders invest their profits in stocks to build long term wealth, and many investors also try their hands on trading stocks. It all depends on personal goals, preferences and circumstances.
Ask yourself the following questions. The answers might give you an idea whether investing or trading is suitable for you (or both).
- What is your objective (wealth building or income generation)?
- How long is your time frame to make money (long term or short term)?
- What is your risk tolerance?
- How much time and effort are you willing to spend on studying the stock market?
- What is your career and lifestyle goal?