On the surface, stock trading and investing in stocks appear to be similar activities. They both involve buying shares in publicly traded companies for the purpose of earning money. Hidden beneath the surface, however, are significant differences which can radically affect the value of your portfolio.
Stock traders tend to hold stocks for no longer than a few months. Day traders focus on holding stocks for less than a day. A scalper may buy and sell the same stock several times during a single day, attempting to make a very small amount of money each time to stock price fluctuates.
Stock investors tend to buy stocks and hold them for years — perhaps until they retire and use the accumulated wealth to fund their golden years.
Capital and Time Requirements
Stock trading can be done in a meaningful way with less capital than investing, because stock trading is more active and involves greater risk. $50,000 (for example) is a lot larger number to a stock trader than to a stock investor, because the stock trader must keep analyzing his holdings to determine if it is time to make a trade, while an investor will perform that analysis much less frequently. Stock traders like to keep their trades relatively smaller, because their risk is higher. This is because stock traders are more vulnerable to short-term market fluctuations. The stock trader invests far more time and energy into his trades, and by doing so hopes to achieve greater returns on his investment capital in a shorter term. The stock investor spends less time watching market fluctuations and accepts lower returns (theoretically) — usually because his time is more valuable invested elsewhere, such as earning money to invest in the market.
Investors tend to look at fundamental factors that affect the value of companies in the long-term. These include the quality of the company’s products, the perceived value of a company’s brand, the membership of the board of directors and the executive management team, potential growth (or shrinkage) of the market for the company’s products, and potential government regulations which could endanger the company. The investor weighs these factors against performance statistics such as the price-to-earnings ratio.
Traders tend to look at shorter-term factors such as market momentum, news items, and seasonal fluctuations.
Speculating vs Believing
Stock traders buy shares, speculating that they will go up in price. Stock investors buy shares, believing that the companies represented by those stocks will go up in value. Investors are not concerned with short-term fluctuations in the price of a stock, because they believe in the long-term value of the company. Stock traders are not deeply interested in the long-term value of a company, as long as they can close out their positions before the company’s shares decline.
If a stock dips in price, a trader will sell the stock to cut his losses. An investor, on the other hand, will see the same event as an opportunity to buy more shares at a lower price point.
Many governments tax profits from investing and trading differently, based upon ill-formed prejudices against stock trading as being some sort of inherently malicious act. Every jurisdiction defines the differences between the two types of stock purchasing differently. One common measure is that profits from investments held for more than one year are taxed at a “long term capital gains rate”, while profits held for less than one year are taxes at a “short term capital gains rate”.
These rates, and the methods for calculating them, differ from nation to nation. They also differ between states within some nations. They also differ from one year to the next. There are, as usual with tax systems, more exceptions than rules. In general, however, expect to pay a 10-20% higher tax rate for stock trading than for investing in stocks.
Stock traders speculate on the value of shares. This is serious work for dedicated professional analysts. This is no place for retail investors, no matter how brilliant you are. It is not an issue of your brilliance, it is an issue of how much insider information you possess. If you do not possess significant insider information, you should not be trading stocks.
Investors, on the other hand, buy shares in public companies in order to own a portion of those companies. They buy based upon their perceptions of the companies value and then they hold those shares for an extended period of time. This is how serious stock market investors like Warren Buffet make money.
Even this is not the right strategy for every investor. It can, and should, require hundreds of hours of research into a company before making a decision to purchase shares. This research is, frankly, beyond the skills of most retail investors. We simply are not as smart nor as knowledgeable as we think we are.
Mutual Funds and Exchange Traded Funds
For most retail investors, the best strategies are mutual funds and exchange traded funds (ETFs). The definitions of both, and the differences between the two, are both arguable and malleable. Mutual funds are collections of stocks (and other investments) which are actively managed by a professional analyst. In effect, for a small fee you are paying a professional investor to make buy and sell decisions for you. ETFs are unmanaged collections of stocks. You can buy or sell an ETF, but you cannot decide which stocks are part of your ETF. By eliminating the management fees of the mutual fund, ETFs usually provide a higher effective rate of return over the long term.
With a mutual fund or exchange traded fund, you don’t need to pick individual stocks either for short-term trading or long-term investing. Instead, you distribute your investment capital (and the associated risk) across a large number of stocks. This provides a (relatively) stable investment while at the same time providing returns which are larger (over the long-term) than debt-based investments like bonds.