Investing/ Trading which is for you
There are questions that are sometimes asked by newcomers to the financial markets and sometimes even discussed by experienced participants. The question is how to differentiate between trading and investing. Since trading and investing — from a financial markets perspective — are very similar, the two are often considered interchangeable.
In my book, The Basics of Trade, I follow this main theme and introduce the idea that what distinguishes the two is the definition of scope. After all, both trading and investing are at the simplest level of using capital for profit. When I buy XYZ stock, I expect either a price increase or a dividend gain — maybe both. However, what distinguishes trading from investing is that in trading one usually expects an exit. This can be a price target or a position holding period. After all, it is clear that trading has an end in life. Investments, on the other hand, are more open. Investors buy shares in the company, if at all, without a predetermined idea of when to sell.
We can use an example to show the difference. Warren Buffett is an investor. He bought a company he thought was somehow underrated and held onto his position while continuing to like their prospects. He didn’t think about the price at which he would leave his shares. George Soros was (or at least while he was still actively managing hedge funds) a trader. His most famous trade was short the British pound when he thought the currency was overvalued and was ready to be withdrawn from the European Monetary Mechanism. Its position is based on certain circumstances. After the pound was released freely and quickly devalued in the market, Soros came out with a nice profit. It meets the criteria for a predetermined return, making it a trade rather than an investment.
There is another way of defining trading as anti-investment. It is related to how invested capital generates returns. In trading, the goal is to raise capital. You buy XZY stock at a price of 10 and expect it to hit 15 and thus make a capital gain. If dividends or interest are paid on the side, that’s fine, but may only make a small contribution to the expected profit.
In contrast, investment is more sales-oriented over time. The focus is on generating income such as dividends and bond interest payments. Are investors experiencing an increase in the price of capital? Of course, but unlike trading, this is not the main motivation.
With this definition in mind, think about what many people consider to be their greatest single investment — their home. However, according to our second definition of investing, a home is usually not an investment because in most cases it does not generate income. In fact, it adds significant costs in the form of mortgage payments, utility bills, and maintenance. Last but not least, home is a craft. We buy it and hope that over time its value will increase and our equity will increase. And the fact that many people expect to move in and sell in just a few years makes it more of a trade than an investment. (Of course, renting out your own property can be considered an investment unless you give it away, which is certainly more commercial.)
As mentioned earlier, trading and investing seem the same to many people. The buying and selling mechanism is basically the same. Sometimes the analysis you use to make these decisions is also the same. However, intention and definition of purpose separate trade and investment.
