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Investing Vs Trading: An Introduction
People new to the world of investing have many questions and dilemmas, such as how to find good companies to invest? What factors to be considered? What will be the right entry and exit point, and so on. Out of all these questions, the one that really boggles their minds is whether to choose trading or investing as a method for profiting from stock market.
Investing Vs Trading:
Investing and trading are two different methods of profiting from financial market. While investing is a way of building wealth by buying and holding a portfolio of stocks for a long period of time, trading involves frequent buying and selling of stocks, profiting from sudden changes in the price, largely influenced by demand and supply factors and general market sentiment.
Investors use compounding growth or reinvestment of profits as a tool to grow their capital over a long period of time. Investors also benefit from many perks such as dividend income, bonus issue of shares, stock split etc. Investors look for the quality of business behind the stock, its past performance future growth potential and compare the business value of the company against the value offered by the market.
Traders, on the other hand profit by analyzing the market sentiments, and look for stocks that may see huge up move in a short span of time. Traders then buy these stocks for a short span of time and exit their position as soon as the price hit the target. To minimize their losses traders also use a strategy called stop loss, where losing positions are automatically closed out, minimizing the potential loss.
Both trading and investing have been effective ways of profiting from the market. The question is which one is more profitable? and how put them to practice successfully in order to make money? In order to weigh both against each other, it is necessary to look at the advantages and disadvantages of trading and investing. Let us look at both of them one by one:
Advantages of Trading:
Following are the major advantages of trading:
Traders can outperform the market:
Traders look for high return on their investments by buying at low price and selling at a higher price. Once you learn and master the principles of trading, you can earn 15%-20% return on your investments per month. The profits thus generated are more frequent and regular.
Traders can take advantage of a falling market:
Traders can also profit from a falling market by short selling the stock, that is by selling the stock before buying, later. When a trader has a negative view about the stock or the market in general, he uses derivative to short sell the stock and buys back when the prices have corrected significantly.
Traders profits are recurring:
Since traders buy and sell frequently, their profit are pretty frequent and recurring, which can be reinvested to increase their trading capital base. Also, since their investment horizon is very small, their capital does not remain committed in a stock for long time, reducing their exposure to market risk.
Disadvantages of Trading:
There are always two sides of a coin, and trading is not different. Here are the disadvantages of trading you should consider before making up your mind:
Short term trends are hard to predict:
Trying to determine the market movements in short term requires careful analysis of market sentiment and psychology of other traders. Analyzing sentiments is difficult as there are a lot of dynamics involved, making it extremely difficult to predict the future outcomes. This makes trading a high risk-high reward game.
Trading Requires continuous vigilance:
Since trading is a short term game, it requires continuous vigilance of the market movements, which means that you have to be continuously keep scanning the market data, news and trends in order to make money successfully. Not everyone has such a luxury of time, which is why trading stocks is not meant for everyone.
Trading stocks is costly:
Every transaction in the stock market incurs some cost such as brokerage, which is paid to the broker who buys or sells stocks on your behalf, and some taxes. Everytime you buy or sell a stock, you have to pay these expenses. Since a trader buys and sells very frequently, he has to pay this cost on every transaction making it a costly affair.
Investing on the other hand too, comes with its own advantages and disadvantages. Let us look at some of the important pros and cons of investing in stock market:
Advantages of Investing:
Some of the advantages of investing are mentioned below:
Power of compounding works in your favor:
Reminds me of a quote from Warren Buffett An ideal business is one that earns very high returns on capital and that keeps using lots of capital at those high returns. That becomes a compounding machine
Every stock is a part ownership in the business of the company. When you invest in a great business, the power of compounding works in your favor. As the business of the company grows in value, your investments, grow with it proportionately. This allows investors to generate a source of passive income even if they are not working.
Dividend income, bonus issue and many other benefits:
Investing in stocks for long term comes with many additional advantages that traders do not get. Investors not only grow their wealth with a compounding effect, but ?also enjoy frequent cash flows in the form of dividend, bonus shares declared by the company. Dividends can be used to re-invest in the company, making more money for you in the future without investing a penny from your pocket and bonus shares increase your holding in a company as you get more shares against the ones you already have.
Great source of passive income:
When you invest in a company, a one time investment keeps compounding as long as the company keeps growing in value. This creates a great source of passive income for investors as they do not have to worry about day to day market fluctuations. A cursory look at the business performance of the company and some changes in your portfolio (if needed) is all an investor has to look at once in a while.
Disadvantages of investing:
There are certain circumstances where investing may become a disadvantage and may not be suitable for some people. What are those? Let us find out:
Requires long term commitment of capital:
Since investing is a long term game, it requires you to commit your capital for a longer period of time, which exposes your money to various risks you may not be comfortable with. Investing for long term also requires lot of patience and higher risk appetite as you may lose all your capital if you investment decision goes wrong.
A slow method of earning money:
If we compare the percentage returns earned from trading vs investing, the percentage of return in investing is much lower. An investor may be happy to earn 15-20% return per year, while a trader, with some experience and analytical skill can earn 15-20% per week!. If you have a knack of finding the right stocks that will go up in short term, you may be wasting your time investing instead of trading.
It cannot be an active source of income:
Investing is a passive source of income, which means it requires long term commitment of funds. Unlike any business or job, where money keeps flowing in on a regular basis, investing does not create a cash flow, making it difficult to make a living out of it.
Trading Vs Investing: How to choose?
The biggest question now is how to choose whether you should be a trader or an investor? There are no straightforward answers. To understand which method of money making suits you better, you need to analyze following traits about yourself:
Analyze your risk appetite:
The first thing you have to understand is how much risk are you willing to take for making money. Trader take higher risk compared to investors, and are usually rewarded with higher returns in a small span of time. To understand your risk taking ability, you must start trading with a virtual account and test your trading skills. If you make money consistently for a long period of time, great, but if you lose money, just ask yourself, would you be okay losing the same amount of money in real life? If your answer is yes, then you are probably ready to trade.
If you have a relatively lower risk appetite and cannot digest huge losses, investing is a better option for you.
The second deciding factor is how much time are you willing to give to your investment. If you are the ones who always keeps an eye on the market, and loves doing that, then you can be a trader. On the other hand if you are one of those who just dont want to work hard and let money do the work for you, then investing is a better option for you.
How do you understand the market:
The third factor that decides whether you are a trader or an investor is how you understand the market. If you are better in identifying the chart patterns and can analyze the behaviour, trading could make you really rich, on the other hand if you have better understanding of businesses and can analyze financial statements in a better way, then investing is the way for you.
How to be a good trader:
Every game has some rules, trading or investing is no different. There are some rules of trading that every investor must follow in order to make money consistently. Let us see all of them one by one:
Stick to your strategy:
The first requirement of being a successful trader is to devise a strategy and sticking to it. A trading strategy is a set of specific rules written that specifies exact entry and exit points and money management criteria. Trading strategy also allows backtesting on previous financial data to test the viability and success of the strategy you are trying to use. Once the strategy is developed and shows good results on back tested data, the plan can be used to trade in real trading. Taking trades outside the set rules and strategies is a dangerous game and may end up in huge losses.
Do not over trade:
Most traders fail to draw a line on how much they should trade in a day especially when they have had a pretty good profits during the day. When money comes easy, everyone want more of it. This is where traders have to learn to draw a line. Overtrading is a result of greed that may have negative consequences on your trading profit. It is similar to gambling, where a person winning easily, makes higher bets expecting higher returns.
A disciplined trader must know when to call off a day, irrespective of whether he is earning profit or suffering a loss. Being realistic and practical about your trading is the only way to be successful.
Maintain strict stop-loss:
A stop loss is a predetermined risk a trader is willing to take for each trade. It it one of the most important aspect of trading as most traders think they can take bigger risk compared to what they can actually take. Stop loss prevents your trading portfolio form huge losses and takes some emotions off your trading day. Using a stop loss ensures you have a limited loss and limited risk.
How to be a good investor:
Understand the business behind the company:
Unlike traders whose profits depend on the large price swing in the stock price, investors on the other hand, profit from the growth in the business behind the stock. Healthier the business growth, higher will be the profit of the investor. Understanding the business and its growth potential is vital component for successful investing. An investor willing to invest in a company must understand the business in detail such as how does the business make money, the cost of doing business, profitability, debt and other vital statistics of the company. This helps investor in analyzing the quality of the business and its growth potential in the future. Based on these parameters, investors ty to project the future growth of the company and assess the expected future returns.
Buy them with sufficient margin of safety:
A good company is not a good investment if you pay too much for it. The secret of making money in stock market is to find the right balance between the price you pay and value you get out of it. Stocks discount future earnings of a company to present value, which is why they trade at multiple times companys present earnings. An investor needs to evaluate the intrinsic value of the company and buy when the stock is trading below or close to its intrinsic value. In other words, good stocks bought at a bargain, held for long term is the simplest, yet most effective strategy of successful investing.
Believe in your principles and unfollow the herd:
Every true investor knows that the market is driven by sentiment. Market surges and declines are mainly caused by two emotional factors; fear and greed. Average investors invest based on these emotions but successful investors have a stronger control over these emotions. They don’t allow the talks of investment pundits or financial advisors affect their choice or method of investing.
Successful investors don’t abandon their investing strategy simply because of a few failures and they don’t become over confident when they are on the winning side. No matter the market conditions, they still respect the 50-50 chance of winning or losing.
Both trading and investing have been proven to be successful methods of money making in the stock market. While trading requires continuous tracking, discipline, and quick decision making, investing on the other hand is more laid back and relaxed approach. Both have their own advantages and disadvantages, what suits you better is something to be decided by you. After all, it’s your money at stake.