Those involved in the stock market have many ways to make money, but these strategies can be summarized into two major strategies: investing and trading. You could say the difference between each strategy comes down to two things: time horizon (how long you’re willing to hold a position) and mindset (whether you think like an owner or like a flipper looking for short-term profits). term).
Contrary to what you see in Hollywood movies and television, research suggests that the vast majority of market participants – virtually all of them – would do better if they adopted an investing mentality rather than a trading mentality. And that’s because of the many subtle costs and inefficiencies of trading.
Here’s the difference between investing and trading, and which option is likely to work better for you.
Investing vs. Trading: How They Differ
“With trading you make money by trading; with investing you make money by waiting.” That’s a sentence that could sum up an important difference between investing and trading. Let’s break down the other key differences to see how they compare:
To invest
When you invest, you think about your investments in the longer term and do, for example, the following:
- As an owner, you think about how the company will perform, not just what the stock will do.
- Your long-term returns depend fundamentally on the company’s performance, not on your skills at buying and selling better than other traders.
- You think of the company as a business: its products, the way it competes, and the developing rivalries within the industry.
- You don’t have to worry about the daily fluctuations in the stock price, especially if the company’s long-term trajectory is on track.
- Because you think further, you shake off negative market reactions in the short term, for example when the company announces quarterly figures.
- You can patiently monitor your investments as they grow.
- You see a stock or fund decline as a potential opportunity to own more shares in good companies at a discounted price.
- When you invest in funds you tend to take a more passive approach, adding money to your portfolio regularly rather than trying to time the market.
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You sell investments based on process and discipline – when the investment case is played out – rather than because they performed well this week or month.
Being an investor is about your mindset and process – long-term and business-oriented – rather than how much money you have or what a stock has done today. You find a good investment and let the success of the company determine your returns over time.
Trade
When you trade, you are much more focused on the short term and less interested in the business as a business. You’ll probably do some or all of the following, such as:
- You are less interested in whether the underlying company will prosper and more interested in whether the shares can make you money.
- You want to know what other people think about a trade, because you are not only playing with the stock or fund, but also with the other players at the table.
- Maybe you’re looking at short-term price movements, even looking at charts minute by minute to predict the best time to buy or sell, and ‘timing the market’.
- Stock prices determine your behavior rather than the fundamentals of a company.
- You tend to ride momentum stocks and look for stocks that rise today rather than stocks that are priced with a margin of safety.
- Your holding period is usually short (maybe just a day if you are a day trader, or maybe a few weeks or months) depending on your specific strategy.
- You can sell investments based on process and discipline, but those trading rules have much more to do with how much you made or lost than with the business itself.
- You may need to pay more attention to the market than you would as an investor because you have to make buying and selling decisions on a regular basis.
Traders generally have a short-term orientation. Being a trader is less dependent on analyzing a company than it is on looking at its stock as a way to make money – and ideally, the sooner, the better. Success here depends on outsmarting the next trader, and not necessarily on finding a great company.
Types of traders
- Day traders. These traders do exactly what it sounds like they do: trade positions all day long. They typically do not hold overnight positions and therefore buy and sell on the same day.
- Position traders. This type of trading uses longer-term charts to identify trends that traders can act on. These traders are positive when the market is rising and negative when it is falling, and only buy or sell when a trend has been established. When things change, they usually leave their positions.
- Swing traders. A swing trader will attempt to analyze and identify when a trend is about to change and take positions to potentially profit from that change or swing. These trades are typically held for longer than a day, but shorter than those held by position traders.
- Scalping. This is one of the fastest methods used by traders, taking advantage of a short-term imbalance in supply and demand for a security that causes the bid-ask spread to become wider or narrower than normal. These traders rely on a large number of small profits and prefer to work with highly liquid securities.
Investing works better than trading for most
If the distinction between investing and trading is a lot like that between active investing and passive investing, then it should be! These pairs of investment approaches have many similarities.
Passive investing is a buy-and-hold strategy that relies on the fundamental performance of the underlying companies to increase returns. So when you take a stake, you expect to hold it for a while and not simply sell it when the price rises or before the next person loses their stake.
By investing passively through funds (ETFs or investment funds) you can benefit from the return of the target index. For example, the Standard & Poor’s 500 index has returned an average of about 10 percent per year over time. That would be your return if you had bought an S&P 500 index fund and not sold it.
Active investing is a strategy that attempts to beat the market by trading in and out of the market at favorable times. Traders try to pick the best opportunities and avoid falling stocks.
While active investing seems to be the consistent winner, research shows that passive investing typically wins the majority of the time. A 2024 survey from S&P 500 Dow Jones Indices found that 93 percent of fund managers investing in large companies have not beaten their benchmark index in the past 20 years. And over time, only a handful could do this, with 92 percent of professionals unable to beat the market over a 15-year period.
These are professionals who have experience, knowledge and computing power to help them excel in a market dominated by turbo trading algorithms with well-tested methodologies. That leaves very few crumbs for individual traders without all those benefits.
So investors are more likely to prefer a passive approach to the markets, whether investing in individual companies or funds. Traders tend to prefer an active approach.
3 hidden trading costs to be aware of
Trading comes with a number of hidden costs, things that ultimately make it less profitable for most traders than sticking to an investment approach. Here are three of the most common:
1. Trading is a zero-sum game
Trading takes place on the basis of a so-called zero-sum game. That is, if someone wins, it is at the expense of someone else. For example, options trading is essentially a series of side bets between traders on the performance of a stock. If a contract is $1,000 in the money, the winning trader gets exactly that money, essentially taking over from the losing trader.
So trading is nothing more than shuffling money from player to player, with the sharpest players taking in more money from less skilled players over time. Investors, on the other hand, play a positive sum game, where more than one person can win. Investors make money when the company is successful over time.
2. It’s easy to miss the big days as a trader
Traders may think they are being crafty by dodging and dodging, but often they miss the biggest days of the market because they are out of the market or only partially invested.
A report from Bank of America shows that exiting the market can be so damaging. The data shows that the S&P 500’s total return between 1930 and 2020 was 17,715 percent. But what is the total return if you had missed just the ten best days of the market each decade? The result: a total of just 28 percent over the entire period, while fewer than 100 days were missed in total.
Market experts have a saying: “Time in the market is more important than timing the market.” That is, it is more important to stay invested than to avoid losses and take profits. And that’s where an investor’s long-term mindset helps you focus on the future. You are experiencing the bad days because the market as a whole has been on a prolonged upward trajectory.
3. Traders raise taxes
Every time you make a profit on the sale of assets, you create a tax liability. So, traders who bounce in and out of the market are constantly realizing profits (or losses). That reduces their ability to compound profits because they have to cut the IRS for a portion of every profit they realize.
Investors, on the other hand, tend to let their investments run their course. And because the government doesn’t require you to pay taxes until you sell an investment, investors can accrue interest at a higher rate, all else being equal. In other words, they effectively force the government to give them an interest-free loan by deferring their taxes, and they continue to settle the full amount before taxes.
For example, imagine you started with $10,000 and earned 20 percent annually for five years, but sold every year and paid 20 percent in taxes every year. At the end of the five-year period, you would have a net worth of $21,000 – good for an annualized gain of about 16 percent. Not bad!
But you’ll have even more if you hadn’t sold. Without selling, you would have turned that $10,000 into over $24,883 and kept the full 20 percent annualized profit. And if you decide to sell? You would still have $21,906 after taxes, or almost 17 percent per year over the period.
That’s a hidden advantage that investors have over traders.
In short
The evidence is clear that investing is a strategy that works better for most people. Can some traders consistently beat the market? Absolutely, no question. But for most people, being an investor is better than a trader – and it can also take less time and effort.
Legendary investor Warren Buffett recommends that investors regularly buy into an index fund like an S&P 500 fund and then hold it for decades. This approach follows the spirit of being an investor: taking a long-term mindset and letting the companies generate profits for you.
— Bank interest Brian Baker contributed to an update of this story.
