There is a question
which is sometimes asked by those are new to the financial markets, and even
occasionally debated by experienced participants. That question is how one
differentiates between trading and investing. Because both trading and
investing – when one considers them from the perspective of the financial
markets – are performed in very similar fashions, they are often thought of as
interchangeable actions.
The Essentials of Trading, I
followed along with this basic theme by introducing the idea that what
differentiates the two is scope definition. Both trading and investing, after
all, are at the most simple of levels application of capital in the pursuit of
profits. If I buy XYZ stock I expect to either see the price appreciate or earn
dividends – perhaps both. What separates trading from investing, however, is
that generally in trading one has an exit expectation. This might be in the
form of a price target or in terms of how long the position will be held.
Either way, the trade is seen to have a finite life. Investing, on the other
hand, is more open-ended. An investor will buy a company’s stock with no
predefined notion of when he or she will sell, if ever.
We can use examples to help demonstrate the
difference. Warren Buffet is an investor. He buys companies which he sees as
somehow undervalued and holds on to his positions for as long as he continues
to like their prospects. He does not think in terms of a price at which he will
exit the stock. George Soros is (or at least was while he was still actively
running his hedge fund) a trader. His most famous trade was shorting the
British Pound when he thought the currency was overvalued and reade to be
withdrawn from the European Exchange Rate Mechanism. The position he took was
based on a specific circumstance. Once the Pound was allowed to float freely,
and quickly devalued in the market, Soros exited with a handsome profit. That
meets the criteria of having a predefined exit, making it a trade, not an
investment.
There is another way one can define trading as
set against investing, though. It has to do with the manner in which the
applied capital is expected to produce a return. In trading the appreciation of
capital is the objective. You buy XZY stock at 20 expecting it to go to 30 and
thereby produce a capital gain. If dividends or interest are paid out along the
way, that is fine, but likely only a minor contribution to the expected
profits.
In contrast, investing looks more toward
income over time. That makes income production, such as dividends and bond
interest payments, the major focal point. Do investors experience capital
appreciation? Sure, but unlike in trading, that is not the prime motivation.
For many people trading and
investing seem like the same thing. The mechanics of buying and selling are
basically the same. Sometimes the analysis one does to make those decisions is
identical as well. It’s the intention and definition of objectives which
separate trading and investing.
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