Welcome to the third article of Poor Sheep!
Trading and Investing are words that a layman might use interchangeably when it comes to putting money in stock markets. However, these words are like two ends of a pole and are contrasting in practice. If you enter capital markets without knowing the difference between these two practices, you might be subject to (several) adversities. Understanding the difference between Trading and Investing and analyzing which one suits your personality and needs better is the first step you should take before entering stock markets. After reading this blog you should get a fair idea of what the two words entail and which one suits you better.
The central and the most important basis of distinction between Trading and Investing is the amount of time for which you hold your position. Anything less than a year falls into Trading. Anything more than a year, you guessed it, falls into Investing.
Traders are generally looking for profits in a shorter term as compared to investors who might hold their position for years or even decades. Traders can be further divided into four categories.
- Intraday — It involves holding positions for minutes or even seconds. With advancing technology people are programming computers to execute multiple trades within minutes to earn small margins of profits on each one. They tend to focus more on technically analyzing (which I will be explaining later in this blog) a stock.
- Day Trading — Day traders typically hold positions for a day or less. They look to open a position in the market only to exit it before the closing bell. Similar to Intraday, they tend to focus on technical analysis but they don’t usually deal in high volumes.
- Swing Trading — Swing Traders usually hold positions for 2 to 6 days, but it might stretch to several weeks. Unlike Intraday and Day Traders, their research is more towards the fundamental aspects like macroeconomic trends or predicted industry growth. However, they might indulge in technical analysis to refine their entry point.
- Position Trading — The time involved in Position Trading is similar to that of Investing. Position Traders use both technical and fundamental analysis before opening a position. Their holding period might range from anywhere between months to years. They eliminate market noise, which intraday and day traders face, by carrying out qualitative research before entering a position.
Another important basis of distinction one must consider before picking Trading or Investing is Risk.
As mentioned before, Traders engage in short-term trades, and in the short term markets tend to be quite volatile. No one can predict for sure if a stock will move up or down in the short term. This means, one bad decision and you could incur a massive loss of capital.
Investing, on the other hand, is generally regarded to be a safer strategy when compared to Trading. This is primarily due to two reasons - long term eliminates the effect of market noise and investors enter positions on the basis of fundamental analysis.
Market noise is a key factor of prices moving up and down in the short term. It can be in favor of the stock or against it. If you’re bullish on a stock and market noise suggests otherwise, you’re screwed in the short term. However, market noise has little to no effect in the long run.
Fundamental analysis of a security is the process through which one arrives at its intrinsic value (true value) after considering important aspects such as macroeconomic factors, the company’s growth potential, its financial performance etc. The end goal is to reach a value and compare it with the market value of the stock. For example, If Stock A has intrinsic value more than its market value and its fundamentals suggest potential growth in the future, the investor might consider buying. On the other hand, if Stock B is overpriced (Intrinsic Value < Market Value) and the fundamentals suggest little growth potential, the investor would be reluctant to buy a stake, regardless of market sentiment or public opinion.
Fundamental Analysis can be further divided into Qualitative and Quantitative Analysis. Quantitative Analysis entails anything which can be measured in numbers, most commonly including financial statements. Qualitative Analysis contrarily focuses on anything which can not be measured in numbers but still might have a considerable impact on the company’s shares. It includes factors such as the company’s business model, competitive advantage and the quality of management. On a larger scale, it incorporates the state of the economy and governmental policies.
Unlike Fundamental analysis which places focus on the company itself, Technical analysis is concerned with historical graphs, trends and other data which help in predicting (or at least try to) where the stock price might move in the short term. It can be carried out for any security which has historical trading data, but one must have proper knowledge and training before delving into it. A limitation of using this technique is that it places no attention on qualitative factors. As a result, a macroeconomic event might drive down the prices of a technically strong share without traders anticipating it.
In conclusion, I think it’s best to try and understand the distinction between Trading and Investing before venturing into the deep-end. Failure to do so might result in big trouble. I hope this blog helped you along your journey of learning about the vast field of Finance. Thank you for reading.