These two terms are often used interchangeably but there are several differences between the two that we will uncover in this article.
What Are The Key Differences Between Trading and Investing?
- Time Frame and Timing:
The period over which the asset is held is shorter in trading. The timing of trading is more important than investing and trading involves more entries at a lower time frame.
- Risk, Leverage and Capital Requirements:
Trading is riskier with more leverage but with lower capital requirements than investing for an equivalent return.
- Capital Growth, Dividends and Compounding:
Trading’s focus is more often to generate an income or short term profit while investing benefits more from long term appreciation through capital growth and the use of dividend compounding.
- Analysis And Strategies:
Trading leans towards technical analysis whilst investing leans towards fundamental analysis.
- Access and Tax Implications:
Trading will have limits based on the risks involved and investing may have barriers when investing in foreign assets. Both will be treated differently in terms of tax implications.
Table of Contents
What Is The Goal Of Trading And Investing?
From a personal level you can say that you invest in yourself if you buy a book; you invest in your knowledge. Or if you exercise you invest in your health.
In economic terms, investing means putting your money (your assets) into financial instruments such as shares, property or a commercial venture with the expectation of achieving a profit.
The range of potential investments is large – you can invest in a pension, mutual funds, bank deposits, stocks, bonds, property, commodities (gold, silver…), start-up companies, cryptocurrencies… you get the idea!
From our previous units we learnt that financial trading is the buying and selling of a derivative product on an OTC market (through a broker) based on an underlying asset’s price, with the intention of making a profit and without taking delivery of any product, except money (profit).
So, on the surface the two sound similar – both are ways of putting your money to work and the goal for both is to make a profit.
Of course they are not the same, otherwise we wouldn’t be talking about the differences, so let’s look at these in more detail.
Time Frame and Timing
The first and most commonly cited difference between trading and investing is the time period over which trading and investing take place.
When we talk about investing we are normally talking about holding positions over a long time period – several months to several years, even decades.
With trading, the time frames are much shorter. This may be as short as a few seconds or minutes, but generally a few hours to a couple of days for short term trades and a few weeks to a couple of months at the longer end.
Timing is the point at which you decide to enter a market. The shorter the time frame over which you are trading, the more important your timing becomes.
That is not saying that timing is unimportant if you are investing long term – timing your entry is always an important factor but more so in a shorter time frame.
The reason for this is that markets move up and down over time, even if a market is in an overall up-trend there will still be periods where the market moves down.
In the example below you can see how you could have entered the S&P500 at any point over the course of a whole year in 2009 and had no issue in exiting the market with a profit 10 years later.
However, if you were a day trader, by zooming into the daily time frame you can see that each red candle was an opportunity to lose money if you were trading in the same year.
Obviously if you are intending to hold something for many years or decades your risk against short term price volatility is reduced but not eliminated.
A common investment timing strategy for further reducing timing and volatility risk is called dollar cost averaging.
What Is Dollar Cost Averaging?
This is a strategy where you would divide up your investment over a period of time and invest a set amount at regular intervals regardless of what the market is doing.
This helps reduce the impact of volatility for that investment and also takes the emotion out of investing.
If you are interested in reading more this article from Nerdwallet.com explains the pros and cons very well.
Risk, Leverage and Capital Requirements
What Is Risk In Trading And Investing?
Risk is a simple concept when it comes to financial trading and investing. It basically means you can lose all your money!
Which has more risk, trading or investing?
Trading and investing both involve risk and trading is viewed as being riskier than investing for several reasons:
- Frequency of trades
The first two we have just covered in time frame and timing.
Trading more often means more risk and trading at a lower time frame increases our exposure to price volatility.
Leverage and Capital Requirements (Margin)
Leverage is where the differences between trading and investing become significant and where a great deal of the additional risk is.
What is Leverage?
Leverage is trading with money you don’t have, like taking out a short term loan. Brokers take a deposit from you – this is known as margin and then loan you a multiple of that amount with which to trade.
This is referred to as the leverage multiple or the margin percentage which is the same thing. In this table you can see some margin and leverage examples.
|Leverage Examples For Assets Based on $1000 deposit (ESMA Guidelines)|
|Leverage Multiple / Margin %||Available to Trade||Products|
|1:1 - 100%||$1000||Investment Products (no leverage)|
|1:2 - 50%||$2000||Cryptocurrencies*|
|1:5 - 20%||$5000||Individual equities|
|1:10 - 10%||$10,000||Commodities other than gold and non-major equity indices|
|1:20 - 5%||$20,000||Non-major currency pairs, gold and major indices|
|1:30 - 3.33%||$30,000||Major currency pairs|
* Use of cryptocurrency CFDs have been further restricted in the UK and Europe and are not available via regulated brokers.
It is possible to get an account with even more leverage than this – 1:500 or more. However, these are the typical levels you will be offered for these products when you open a trading account with a broker in the EU.
This is due to regulation that was put in place to protect retail investors from the risk of using too much leverage.
Leverage and Margin Example:
Let’s have a look at how this works in practice:
We want to buy 0.1 lot (mini lot) of EUR/GBP. 1 mini lot = 10,000 of the base currency.
The price of 1 EUR in GBP is 0.83192. So to buy 10,000 we will need £8,319.
Our leverage for this product is 1:30, so our margin requirement is £8,319.20 / 30 = £277.
Now to see the effect of leverage in action, let’s follow this example through:
The price increases by 1% from 0.83192 to 0.84024. We have bought 10,000 units so the value is now £8,402.39.
That is a profit of £83 against a margin requirement of £277, so a 1% increase in the price has given a 30% profit.
And this is the first reason that leverage creates risk because the opposite of the above is that a 1% drop in the price would lead to a 30% loss of our margin!
But this is not the only reason that leverage increases risk. Those of you who were paying close attention to the example I just used will have noticed something very important that I missed out – fees.
Whenever you open a trade, you will first have to pay the spread or commission, and if you hold the trade overnight, you will have to pay interest on the money that your broker has loaned you to open the trade (otherwise known as the overnight rate or swap charge).
Let’s look at what this means using the example of a 1:1 risk to reward strategy where your target price is the same distance as your stop loss.
However, when you add the spread your risk to reward is diminished. In this case a win would return slightly less than a loss. Which means a ‘breakeven trade would actually be a small loss.
These fees can have a big impact on your profitability because leverage also works to multiply the cost of the fees versus your margin.
This difference, although small, will compound the more trades you undertake. In our example the spread was a very small percentage versus the price (0.01%) But a higher percentage vs the margin (0.3%).
This means that in 40 breakeven trades you would lose 12% of your margin!
This is something you should be aware of when people are showing you their trading strategies, if they are not including charges then they are not being honest. Trading is a probability game and ignoring this is a good way to draw your account down to zero!
In comparison, investments may seem much less risky! However there is still risk involved in investing if it is not done correctly. There are three main things to consider when investing:
- Liquidity/Opportunity Cost
- Diversification risk
So, this may seem obvious but I will say it anyway – just because investing is less risky than trading, it doesn’t mean that you should just pick investments at random!
If you are going to be an active investor and pick your own investments rather than through a financial advisor then you will need to educate yourself to make good decisions.
The good news is that there is plenty of information out there if you look for it and because investing is a long term project, you needn’t make any decisions without taking the time to research it.
With investments your capital requirements are normally 100% of the amount you want to invest (no leverage). This means that you are locking up your money into that investment and won’t have it available for other investment opportunities.
This is the opportunity cost involved in investing in that there may be a better opportunity that comes by and because you are fully invested you cannot take advantage of it.
However, it is worth noting that investing is a way of increasing capital over time and with the effects of dividend compounding (covered next) it is never too early to start investing and better than having your money do nothing.
Long term investments can also often be illiquid. This means that you may not be able to convert it back into cash quickly or if you do, you may have to pay a liquidity premium to do so and sell at a discount to the asset value.
We covered the importance of liquidity in Part 4 of the trading basics series (section 7.2.1). Follow the link for a recap.
Diversification is the most used strategy for decreasing risk in investments. It is a very simple idea – don’t put all your money into just one or a few investments. If your investments are not well diversified then you stand the risk of losing money if the market moves against you.
Diversification allows an investor to limit their risk by investing across a range of non-correlated asset classes. This means that a single market event will not affect all of their investments.
This is a balancing act as the more diversified a portfolio is, the lower the risk but also, the lower the return will be and a portfolio can be over diversified. If in doubt, seek financial advice.
Capital Growth, Dividends And Compounding
Another significant difference between trading and investing is the intent (why we are trading/investing) and the effects of dividends and compounding.
For the most part, investing, being a long term game, is about growing your capital over time. It is about putting your money to work for you so that you can draw on in the future, such as in the case of a pension.
As such the goal for most people when investing is long term capital growth for future income. In comparison, trading is seen by many as a way of generating income not capital growth.
Now, it is important to note that trading an account with a small amount of capital will make it a lot more difficult to draw a sustainable income and as such, there should always be some proportion of capital reinvestment in order to build a sustainable trading account.
Trading As A Financial Independence (FI) Strategy
This is the typical view of trading vs investing. However, there are alternative strategies for trading that some people, including myself employ. This is to view your trading account as part of a Financial Independence (FI) strategy.
What is a Financial Independence (FI) Strategy?
The basic tenant of an FI strategy is to live within your means, build multiple income streams, save, invest, compound, repeat…
In this strategy, because the goal is to build multiple income streams (and probably trading is not yet a primary income stream) we reinvest profits back into the trading capital account.
This means we can use risk limited strategies that aim to return more than investing but do not push the risk too far to try and take an income from a small account. In this way we look to build our capital over time.
One of the greatest benefits of investing are dividends and their compounding effects.
What are dividends?
Dividends are payments made out of a company’s post tax profits to eligible shareholders.
Due to the fact that in investing you own the underlying asset, in the case of share equity this means that you own a part of a company. This, in most cases, infers a right to a share of the profits of that company. These are distributed by companies in the form of dividends.
This payment can then be reinvested by the shareholders as they wish but often are used to buy more shares in that company. These additional shares then go on to earn more dividends and so on. This is called the compounding dividend effect and is one of investing’s biggest advantages.
Compounding starts slowly but creates huge benefits over time. To add to this advantage many brokers will have an option for automatic reinvestment of dividends at a reduced or no fee.
How effective is compounding?
According to dqydj.com, a 40 year investment in the S&P 500 from 1980 to 2020 would have greatly increased returns with dividends reinvested (adjusted for CPI).
|S&P 500 1980-2020||Basic Returns||With Dividends Reinvested|
Active vs Passive and Fees
As we learnt when talking about Risk, traders tend to be more active than investors.
This is another key difference between trading and investing in that there is no way to be a passive trader but there are many options for passive investing.
Passive investing is an investment strategy of buying and then doing, well… nothing. Simply buy and hold for the long term. This is often done in conjunction with dollar cost averaging where a set amount is invested every month into the same investment (or basket of investments).
One of the most common passive investments is index investing, such as in the S&P 500. You may have an ambition to be a trader or master investor but it is worth noting that, in recent times passive investment funds have outperformed the majority of active funds.
I’ve already covered the major impact that fees can have in trading. This is also true in investing and can actually be worse. Why, because it can so easily be forgotten in a long term investment.
If your investment horizon is 25 years you may think nothing of a 2% fee. But that 2% will cost a lot more as you not only have lost the cost of the fee but also the potential compounding effect of that money.
The example below from Vangaurd.com is a great illustration of the potential impact of this. $100,000 invested for 25 years would compound to $430,000 over 25 years with a 6% annual return rate. However, with a 2% a year fee you would lose $170,000 to costs!
Analysis and Strategies
If you are not going to go down the passive route (ie, letting other people invest for you) then you will need to have a strategy and ways to analyse the assets you are reviewing before investing or trading in them.
Investing and Trading will differ in how this is approached. There are two main types of analysis: Technical and Fundamental.
There isn’t a hard rule but in general investing will rely more on fundamentals with some technical and trading will rely more on technical with some fundamentals.
What Is Fundamental Analysis?
Fundamental analysis is a forensic review of an asset whose goal is to determine the intrinsic value of an investment and determine the fair price for that asset.
This analysis can look at a multitude of factors that analyse the component parts of an asset. These analyses fall into two broad categories: top-down and bottom-up.
Difference between top-down and bottom-up analysis:
To illustrate the difference between the two, let’s imagine we want to analyse the intrinsic value of a company.
A bottom-up review would involve looking at factors such as cash flow, profit margin, company leadership. A top down approach looks at the wider sector and macroeconomic factors such as interest rates, GDP growth, price of commodities, competition, etc.
Note: For more information on fundamental analysis you can read our article on it here: Unit 7: Introduction To Fundamental Analysis.
What Is Technical Analysis?
Technical analysis is a method for analysing an asset or market for the purpose of making a trade. Technical analysis focuses on the interpretation of the price movement of an asset over time and the resulting chart patterns and key levels.
As already mentioned in this article, timing is far more important in trading than in investing. Technical analysis is a key element in determining the timing of a trade. For traders this will happen on a lower time frame than for investors.
Note: For more information on technical analysis you can read our article on it here: Unit 8: Introduction To Technical Analysis.
Use of both types of analysis
Investors may make use of technical analysis to improve the timing of their entries even after they have made a decision to purchase an asset following their fundamental analysis.
Traders may make use of fundamental analysis to determine a good market to trade based on a long term or macro trend, but then rely on technical analysis for trading in and out of the market multiple times within the larger trend.
Long/Long vs Long/Short
Another key difference between trading and investing is the use of sell orders (known as shorting the market). Generally investors will only buy assets whereas traders will buy (go long) and sell (go short) assets.
The reason traders can do this is because they are often not trading the asset itself but instead are trading the price and can effectively bet on movement in the price either up or down.
For more information on what financial trading is, you can read the first article in our trading basics series here: Part 1. What Is Financial Trading?
Access and Tax Implications
Closing out this module, it is worth noting that trading and investing are normally treated differently in terms of regulation and tax.
I can’t give advice on this other than to say, do your research as the differences can be significant and will depend on the country or district in which you live.
One of the key reasons for the divergent treatment, will be because of the differences between trading and investing as discussed in this article.
Trading will often involve derivative products and have higher risks associated with it due to leverage and as such will generally be more highly regulated.
Investing will generally involve holding assets over a longer period of time and in many cases will receive preferable capital gains tax treatment and may even have other tax benefits if held for a minimum period or in pensions.
Access to products
Access to various products will also differ between trading and investing. This will also depend on local jurisdictions but in most countries it is a lot easier to access certain products via trading than via investing.
This is due to the impact of technology and derivatives. For example you can trade gold options or CFDs very easily on most available platforms but investing in physical gold will present barriers such as transport, storage and security.
Diversification in investing:
More Trading Basics
There is loads more to learn and we will uncover more terms in the rest of the Trading Basics blog series. Read our previous or next unit.