Since the era of stocks, currencies and most recently the crypto market, active trading of financial assets has been a popular theme. However, the popularity of these trading methods has now grown significantly during the COVID-19 as a significant number of people stay online.
Investing and trading are two different approaches to financial markets. In trading, you hope to earn quick returns from short-term market fluctuations. Investors who are long-term tend to concentrate on diversifying their portfolios and staying with them during the ups and downs of the market.
Many investors — especially individuals — may prefer to avoid trading altogether due to its high stakes and inherent risks. Others, however, may decide to invest some of their funds in long-term investments and other funds in trading. Which is better?
The basics of investing
In investing, money is invested in financial assets (stocks, bonds, mutual or exchange-traded funds, etc.). This money is expected to rise in value over time. Investors have a long-term horizon and tend to build wealth through compound interest and gradual appreciation rather than through short-term gains.
An investment with a short time horizon is more likely to lose money. If you need money within three years, experts recommend that you put it in a savings account. Otherwise, investing would be a much better option. Investing can even be a long-term commitment for some investors.
For investors, diversifying their investments can reduce their risk, primarily by mitigating the effects of volatility (rapid, violent, or unexpected changes in values or prices).
Active investing involves actively buying and selling securities, in order to outperform a benchmark index. In the stock market, for example, an active investor might purchase individual stocks in order to outperform the NSE30 (a Nigerian stock market index that is composed of 30 large capitalized listed Nigerian companies).
Investors who passively invest aim simply to match the market or benchmark index performance over time. In this case, no individual stocks are selected for inclusion in the portfolio. Instead, they invest in index funds and exchange-traded funds, which are geared toward tracking a specific market’s performance.
Using these factors will help you find stocks that are undervalued (Value investing) or have the potential for meaningful capital appreciation (Growth investing).
The basics of trading
A trader buys and sells stocks or other securities quickly in order to make quick money. Traders measure their time horizon in weeks, days, and even minutes, not years, like investors.
Day trading and swing trading are two of the most common forms of trading. Positions are never held overnight by day traders; positions are always bought and sold within a single trading day. On the other hand, swing traders buy assets they expect to increase in value over the next few days or weeks.
Fundamentals are relatively meaningless in the world of trading. Despite the fact that a stock’s value has been expected to increase over the long run, that doesn’t mean it will do so within the next few minutes or even within the next few days. Trading decisions are therefore informed more heavily by technical analysis of market movements and news reports.
Risks can arise when trading. Losing a lot of money in a short period of time is possible when a trade goes against you. A trader’s risk is typically increased by using leverage – or borrowing money or purchasing assets with money they do not have. Short selling, trading on margin, and options are all ways to leverage.
Taking small position sizes (that is, not spending a large amount) can reduce your risk of losing big on a single trade if you’re interested in getting into trading. You may also want to set up a stop-loss order, which will be automatically executed if the asset drops below a certain price (which will limit your losses).
Which one is better?
The two activities, trading and investing, use the same financial markets and assets, however, they have different goals. Comparing the two is challenging.
However, trading is riskier in general for two reasons:
- There is a lot of speculation involved, which includes quick decisions, educated guesses, and just plain gut feelings
- Diversification is minimal (or none) since it is difficult to monitor more than a few trades at once. Also, diversification moderates both ups and downs by its “evening-out” effect – and traders want their highs to be as high as possible.
It should be noted, however, that trading can also mean higher returns. The average portfolio should earn 10% a year. In fact, a trader may hope to earn as much as that per month. The uncompounded annual return of 36% would be earned even by traders earning “just” 3% per month.
Due to these reasons, neither strategy can be considered the “best” way to approach stocks. If you do not want to experience volatility and want to minimize your risk, investing will be your best option. If you like the idea of earning big returns fast but are a risk-taker, trading might appeal to you.
Trading and investing aren’t mutually exclusive, which is why it’s important to understand this. You might, for example, decide to invest most of your money in a diversified portfolio that you’ll hold onto for the long haul, while you set aside the remaining for short-term, speculative trading.
You can earn quick cash by trading. However, as with gambling, you can also suffer large losses quite quickly. There are usually fewer severe losses with investing than short-term wins.
It’s still possible to enjoy trading with a portion of your money if you’re comfortable with the risks.
You should stick with long-term investing if you want to reduce your exposure to risk and volatility. Investing slowly and steadily is usually the best way to reach a financial goal by a specific date.