File photo / Richard Robinson
This week I want to clear up the difference between trading and investing.
Many people are successful in one or the other and some people do both separately and still manage it well. The biggest danger lies in the crossover of the two and letting your trades become investments or your investments become trades. This happens with new traders/investors who do not know the difference between the two and therefore end up making mistakes, not obvious to them, but glaringly obvious to the experienced hand.
First let's establish what each of them is, the major similarities and the biggest single difference and some reasons why trading and investing must not overlap.
Trading versus Investing
Trading and investing have one major thing in common; we are placing our money somewhere today and hoping to make a profit on it in the future. Every time we position our money in this fashion, there is a downside risk that we could lose money and this is equally apparent for both traders and investors. They sound quite similar right? It's no surprise that people new to this domain get them confused and the lines are often blurred.
The biggest difference between the two is the time period over which we plan to keep our money in its new position. Investments are normally for years or even decades. People invest in the family home, they invest in rental property, they invest in Kiwisaver and other managed investment vehicles. Many people invest in the share market by buying stocks today that they think have long term potential and then holding those shares for the long term.
Traders on the other hand have a much shorter outlook and this can be anything from seconds to minutes, hours, days, weeks or months. Once you get into the realm of a year or more, it's a bit of a grey area in some situations but by most (not all) definitions, that's starting to look more like an investment than a trade.
As discussed above, many people 'invest' in property when they buy it and hold it long term. But, people also 'trade' property which can involve a common scenario such as buying a home, doing it up to add value and selling it a few weeks/months later at a profit (or loss)... then doing it again and again. This person would now almost certainly be considered a property trader or using IRD's terminology, a property 'dealer' as compared to an 'investor'.
People can invest in shares for the long term, they can also trade shares in the short term. Trades and investments are not limited to the stock market although stocks are typically the most common 'investors' market. You can also trade or invest in the forex, bonds and futures markets. The difference again is the intention and the timeframe. If I buy a stock with the intention to sell it next week for a profit, that's a trade. If I buy a stock with the intention to sit on it for the long term while watching the company grow; that is an investment.
But what if I buy a stock today as an investment, then next week I see a small profit or loss and close it out prematurely? Or what if I take a trade today which I plan on closing in the next few days, yet the trade starts losing me money so I hold onto it for the long term, 'hoping' it will come back to profit? Now I am mixing up trading and investing and this is a dangerous mistake to make.
Why Trading and Investing Don't Mix
Most people who invest in a managed fund understand the reasons why they are doing it and they are almost exclusively long-term investments - not to mention the entry and exit fees that make it somewhat prohibitive to 'trade' a managed fund! Most people in Kiwisaver for example are saving for retirement, others for an even longer term legacy and some for a first home. The key thing is that it's long term, it is an investment.
Now imagine you invest a starting $5k in KiwiSaver this week and next week it is worth $5200. You think, wow, I have made a profit, let's cash that baby in! Well the restrictions of KiwiSaver probably won't allow you to do that but hopefully you get the point - a long-term investment in this situation would have become a short-term trade.
One of the most damaging (often fatal) mistakes that a trader can make happens when an intended short-term trade loses money and then he or she decides they are not prepared to take that loss. This is already a sign of inexperience as the experienced trader would have cut the loss at their predefined level and moved on to the next trade. The inexperienced trader decides that "it will come back into profit sometime" and they sit on it while unknowingly the short-term trade becomes a long-term investment.
Even worse, sometimes that doomed trader-turned-investor adds to their position... they scale into a losing position, making their risk significantly bigger, all in the 'hope' that it will come back. This single mistake wipes out not only individual traders but it has wiped out banks and large companies when trades became investments and the losses got out of control.
Most weeks in the comment section, I get told about things I missed. Please bear with me! I can't write a thesis each week that covers everything related to financial markets and I am only able to provide small snippets. I try to cover the most important points as I see them and with your suggestions, I will write a lot more about topics that you are interested in. This week's topic for example, was suggested by someone in the comment section last week. I could probably write 10 times more on the topic of trading versus investing and I will revisit it this again in more detail if it is requested by readers.
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