As more and more people become interested in making money through investing and trading, it’s never been more important to be aware of the differences and how to take part safely.
Investing and trading are two different methods of attempting to profit in the financial markets. In general, investors seek larger, more passive returns over a longer period of time through buying and holding positions/assets. Traders, by contrast, attempt to take advantage of both rising and falling markets to enter and exit positions over a shorter timeframe, taking smaller, more frequent profits.
This article will look to outline and detail the difference and similarities between investing and trading. We will discuss different methods for each, with the associated benefits and disadvantages, and the potential risks involved.
Investing
The word “invest” simply means “to clothe”, describing the act of allocating resources, usually money, with the expectation of generating an income or profit. You can invest in endeavors, such as using money to start a business, or in assets, such as purchasing real estate in hopes of reselling it later at a higher price.
A journey back in time: The beginning of investing
While the concept of investing has been around for thousands of years, investing as it currently exists originates back to between the 17th and 18th centuries, when the development of the very first public markets connected investors with investment opportunities. The Amsterdam Stock Exchange was established in 1787, followed by the New York Stock Exchange in 1792. The Industrial Revolutions of 1760-1840 and 1860-1914 led to greater prosperity, as a result of which people amassed savings that could be invested, fostering the development of an advanced banking system. Most of the established banks that dominate the investing world today began in the 1800s, including Goldman Sachs and J.P. Morgan. The 20th century gave rise to investment theory, with the development of new concepts in asset pricing, portfolio theory and risk management. In the second half of the 20th century, many new investment vehicles were introduced, including hedge funds, private equity, venture capital, REITs (Real Estate Investment Trusts) and ETFs (Exchange-Traded Funds). In the 1990s, the rapid spread of the Internet made online trading and research capabilities accessible to the general public, completing the democratization of investing that had commenced more than a century ago.
Investing today: The basics
The motivations of an investor can vary, there are some who invest as to make a living, whereas some have disposable capital who simply wish to increase their wealth. Others simply trade as a hobby, without implementing too much strategy or being too concerned over any losses that may arise.
Opportunities for investors can come in many forms. Exchanges and trading platforms are very easy ways to become involved, as most are eligible to register and there are no minimal capital requirements. Then there are those with larger barriers to entry, which require a large amount of capital to access, e.g. funds for high net-worth individuals, or real estate.
Before we take a closer look at how and where to invest today, a few basic misconceptions need to be resolved:
Investing and saving are two different pairs of shoes
Saving and investing often are used interchangeably, but there is a difference. Saving is setting aside money for emergencies or a future purchase. It’s money you want to have immediate access to, with minimal risk, and with the least amount of taxes. Financial institutions offer a number of different savings options. Investing, however, is buying assets with the hope that your investment will make money for you. Investments usually are selected to achieve long-term goals. Generally speaking, investments can be categorized as income investments or growth investments.
Income growth vs. growth investment
Income growth is simply generating an income from having invested money, e.g. a dividend from a stock you’ve invested in might pay you a regular sum, or a bond purchased might regularly pay interest to you – both of these are income generated from your investment. Growth investment is, as the name suggest, growing the original sum invested, whereby the difference between the growth and original amount invested is the profit. Examples of this are stock which might not necessarily pay a dividend, but might appreciate in value as the company grows.
What is being invested in?
Some of the most common forms of investing nowadays are stocks, commodities, cryptocurrency, bonds, stock, investment funds, and real estate.
Stock
Stock represents stake in a company – also known as shares. It essentially represents owning a portion of the company, and depending on the terms, owning this stock can give you certain rights and control over the company, as well as paying a dividend (a regular amount paid out to you – not too dissimilar to interest). For stock that doesn’t pay a dividend, the owner will simply hope to make money from the increase in value of the stock. Stock is a very popular investment choice, with 52% of US adults holding money in the stock market and it’s no surprise, seeing the global stock market value is roughly $80 trillion.
Stocks are a riskier form of investment since they are entirely dependent on the performance of the company the stock is associated with. Any stock can potentially plummet overnight, and equally, its value can spike, leading to significant gains. What’s also appealing about stock is how accessible and liquid they are – almost anyone can purchase stock, and they can be sold back on the market at any moment as long as the market is open. Because of their riskier nature, it’s not advised to invest more than you are willing to lose in stock. It’s also wise to reduce any unnecessary risk (known as diversifiable risk) by investing in different stocks from different companies in different sectors.
Stock can be purchased over the counter (OTC) if it is held privately. However this is usually only for investors with a significant amount of money to invest. Once a company is public (after an Initial Public Offering), it’s shares can be traded openly on a variety of stock exchanges online. There are numerous trading platforms online which facilitate this process. An IPO (Initial Public Offering) is the issuance of shares to the public for the first time, usually with the intention of raising capital.
Crypto Assets
Crypto assets are digital assets that are stored and secured using blockchain technology. They are the most well-known example of decentralized finance (DeFi) and are becoming more and more important in the world of finance and business. The most common form of investment within crypto assets is cryptocurrency. With the advent of Bitcoin and other cryptos, popularity with this form of investment has sky-rocketed. Security Token Offerings (STOs) are the crypto-world’s IPO. With STOs, a token is issued in place of a share, that represent a stake in the company which is immutably stored on the blockchain. Investors can have their investment recorded with cryptographic security whilst also investing in the future of the company.
- Crypto assets are growing quickly in popularity, and there are many reasons for this. Decentralization is very appealing to lot of people – the idea that the system is governed by those using it; everyone sharing a consensus of every transaction to have happened on the blockchain means there is no need for an intermediary, such as a bank. With this, comes a great reduction of fees associated with third-parties.
- Furthermore, the lack of middle-men means a lack in differences between middle-men. Usually, cross-border transactions take much longer and require more man power to ensure security and speed. The blockchain recognizes no such borders so international transactions are as easy as any other.
- Finally, it’s not simply ‘shares’ that tokens on the blockchain can represent (these are known as security tokens). Utility tokens can grant investors special rights and access to resources/functions that others won’t have. Non-fungible tokens have the exciting prospect of being able to offer unique benefits and opportunities that vary from one token to another – they can represent anything you can think of from physical assets to ownership rights to property.
There are also risks associated with certain crypto investments – cryptocurrencies do offer the potential of huge gains, but with this comes a much greater volatility.
However, with cryptocurrencies, the accessibility is much the same as with stocks. In fact, some platforms that allow for the trading of stock, also simultaneously allow for the trading of cryptocurrency.
Commodities
Commodities are raw materials and unprocessed goods that are either consumed directly or are processed and resold, such as gold, oil, wheat, cattle and aluminum. These products are essential to everyday life and the demand for such goods will likely not change significantly for some time.
There are some interesting benefits to holding commodities. Investing in commodities may minimize portfolio volatility, due to their low and often even negative correlation with traditional assets, so including these sorts of goods in your portfolio is a good way to diversify. Commodities can also be utilized to hedge against inflation. Commodity prices often track with inflation and may provide an insurance against the impact of ever-rising prices. Commodities can be physical assets – hard commodities, such as gold and other precious metals, may be considered a store of value. This is especially the case when a base level of demand exists. As demand rises, there may be potential for price increases.
Even though commodities can be a good idea to add to a portfolio for diversification, as a lone investment they can be riskier than traditional assets. Commodities form an integral part of most people’s lives, so the demand rarely changes, at least not in the short-term. This means any change in supply, due to things such as weather or geo-political events, can cause drastic price changes in the commodities market. Higher volatility means higher risk, even if the potential gains might be greater. Furthermore, past trends have shown commodities to have a relatively small return as a long-term investment, and yet a higher volatility when compared to cash and cash equivalent assets.
There are several ways to invest in commodities, from simply purchasing and physically owning the goods, to investing in mutual funds (more about this below) and Exchange-Traded Funds (ETFs) that comprise various commodities in their portfolios. These are some of the easier ways to add commodities to your portfolio, but more sophisticated and wealthy investors may have access to specific commodity brokerages.
Bonds
Bonds are simple debt instruments that are essentially loans. Like most loans, there is an interest rate associated with them – this is the benefit of investing in bonds. Depending on the nature of the bond, this interest will be regularly paid sums (known as coupons) to the bond holder, up until the bond reaches its maturity date, at which point, the initial price of the bond (the principal amount) will be repaid in full.
Governments issue bonds to fund large scale projects, and these kinds of bonds are virtually risk-free, usually meaning the interest paid out is often no better than that you could get from a bank. Riskier bonds can be issued by companies looking to raise funds, and the higher risk is usually associated with a higher rate of interest. Bonds are rated by companies based on their riskiness (Standard & poors rate bonds, for example), with the riskiest of bonds (known as junk bonds) being the most poorly rated. These kind of bonds are usually issued by financially unstable companies looking to raise money quickly. These companies are usually liable to default on such bonds, but if they do pay out, they interest rates are usually very good.
A downside to bonds is you won’t be able to retrieve your initial principal amount from the issuer until the bonds maturity date, unlike if you had put your money in a bank, where you are free to make a withdrawal whenever. You may sell the bond to someone else, but there are often fees associated with this.
The bond market does not have a centralized location to trade, meaning bonds mainly sell over the counter (OTC). As such, individual investors do not usually participate in the bond market. Those who do, include large institutional investors like pension funds foundations, and endowments, as well as investment banks, hedge funds, and asset management firms. Individual investors who wish to invest in bonds may do so through a bond fund managed by an asset manager, which of course will cost them some of their profits. Many brokerages now also allow individual investors direct access to corporate bond issues, treasuries, municipals, and other bonds.
Investment Funds
Funds can take many forms, with most common being mutual funds. A mutual funds is run by an investment specialist, such as a portfolio manager, who will charge fees or take a cut on the profit made from your investment. A mutual fund is a pool of money from several investors diversely invested in different financial instruments, such as the aforementioned stocks and bonds. Because of this diversity, it’s a less risky investment.
Profit can be generated from mutual funds in several ways. Any dividends paid out by any stocks or bonds held will generate an income to the investors. Equally, the manager of the mutual fund may decide to sell stock that has increased in value, with this profit benefitting the investors. Furthermore, if the overall value of the fund increases due to change in the prices of the stocks, an investor can choose to sell their share in the fund to another investor, cashing out and realizing any profit, meaning a mutual fund investment is highly liquid.
Despite all these benefits, and a lower risk, there are downsides. Notably, the fees taken by the manager of your funds can cut into your profits – profits that you could keep for yourself in their entirety if you invest yourself. However, buying various stocks and financial investments to build a sufficiently diversified portfolio can be time consuming and effort, so some choose this as a less profitable, but more convenient method of investment.
An example of an alternative investment would be a hedge fund. Hedge-funds are usually very exclusive and only available to high net-worth individuals. Hedge funds are called so due to their traditional strategy of buying long and short positions on stock, making a profit whichever direction the market shifts in. However, nowadays, hedge funds employ a much more aggressive strategy of shorting or going long. This means the profits can be significantly higher, but as usual, the risk is much greater.
Finally, another common form of investment, is a pension fund. This is usually an investment made over a career in which some of your salary is pooled into a fund. Your employee may also match any contributions up to a certain amount. The pension fund will then invest the pooled monies of all the people paying into the fund, into stock, derivatives and other forms of investment. The gains will then be distributed to the investors once they retire from work, and regular payments will be made to them from then on. Pension funds are very popular, with Morgan Stanley estimating the total value of all pension funds around the world to be worth $20 trillion. Pension funds are attractive since any sum paid in is usually matched by an employer, and the investment normally comes with a huge tax benefit.
In short, mutual funds, and especially ETFs are very accessible – as much as stocks. Pension funds are mandatory in a lot of jurisdictions, and hedge-funds are very exclusive.
Real Estate
Real estate investment is investing in property, whereby profits can be derived from rental costs, or by selling after the property has appreciated in value (as real estate tends to do). One can choose to take a more active role in owning property, or a more passive one by investing in something like a Real Estate Investment Trust (REITs) – which is similar to holding stock.
Real Estate offers many benefits. As mentioned above, real estate tends to appreciate in value, which can often counter the negative effects of inflation on your profits. Another huge benefit is how one can use leverage to own an investment worth 5-10 times more than the total funds you have available (known as a mortgage). One more benefit is the steady increase in equity. When you take out your mortgage, you will essentially be using the money your tenant pays you to pay off this loan – it could be thought of as the tenant paying off your loan, and slowly, you own more and more of a hugely valuable asset, until eventually, you own the asset completely; at which point, you can choose to continue with your tenancy, without having to pay back any mortgage, or you can sell the property.
Even though real estate can be a very powerful investment, it does require a large initially payment. Even if it is just 10% of the value, that will usually be many thousands of dollars or equivalent. Managing property is also a lot of time effort and can have unique expenses associated with it that aren’t with other form of investment, such as maintenance fees, property taxes, and insurance. There is also a risk associated with the kind of tenant renting your property, and the probability of them not paying the rent. Ultimately, real estate has great potential as an investment, especially when used to diversify. Finally, property is highly illiquid.
Generally speaking, anyone has access to the real estate market, providing they have the large initial capital required.
Different Investment Strategies
Active Investing
Active investing, as its name suggests, is a more direct approach to investing and requires an individual (or someone else on their behalf) to act as the role of portfolio manager. The goal of active money management is to try to beat the stock market’s average returns (that might be made from passive investing) and take full advantage of short-term price fluctuations. It involves a much deeper analysis and the expertise to know when to pivot into or out of their chosen investments. To succeed with this method of investing, consistently, and without being lucky, requires a great deal of heavy statistical and quantitative analysis – it is a common misconception that the average individual could and/or should engage in active investing; doing so without carrying out the aforementioned thorough analysis is no different to gambling and is highly speculative. In fact, 90% of actively managed funds underperform passive funds. A portfolio manager usually oversees a team of analysts who look at qualitative and quantitative factors, and even then, there is still a degree of speculation. Simply put, a good active investor knows when the right time is to buy and sell assets, and a successful one is more often right than they are wrong, on a consistent basis.
Passive Investing
A passive investor will be holding its investments for a long period of time, often years, with an effort to see long-term returns. Passive investors heavily limit the volume of buying and selling within their portfolios, avoiding transaction fees, making this a more cost-effective way to invest. The strategy requires a buy-and-hold mentality which means resisting the behavioral bias to react to or anticipate any events or changes in the market.
A notable example of a passive approach is to buy an index fund that follows one of the major indices like the S&P 500 or Dow Jones Industrial Average (DJIA). Whenever these indices switch up their constituent stocks, the index funds that follow them automatically switch up their holdings by selling the stock that is leaving and buying the stock that is becoming part of the index. This is why it is important when a company becomes big enough to be included in one of the major indices: It guarantees that the stock will become a core holding in thousands of major funds.
When you own a diversified portfolio of many different stocks, your returns are derived from the upward trajectory and collective performance of those stocks, and hence the overall performance of the stock market. Successful passive investors are able to ignore their bias toward reacting to the stock market, even after sharp downfalls in price, or large positive increases. According to an academic study of frequent traders by Brad Barber and Terrance Odean, the most active traders reaped the lowest returns. Indeed, between 1992 and 2006, fully 80% of active traders lost money and “only 1% of them could be called predictably profitable.”. The historical data strongly favors passive investing. An important quote with a lot of truth behind it was said by Bill Lipschutz: “If most traders would learn to sit on their hands 50 percent of the time, they would make a lot more money”.
Growth vs Value
When considering your approach to investing in the stock market, an important factor to consider is to what extent the company is considered to be a growth or value stock.
Growth stocks are those companies that are considered to have been and continue to show potential to outperform the overall market over time because of their future potential. Value stocks are classed as companies that are currently trading below what they are truly worth and will thus provide a better return.
- Growth stocks, in general, have the potential to perform better when interest rates are falling and company earnings are rising. However, they may also be the first to be punished when the economy is cooling.
- Value stocks, often stocks of cyclical industries, may do well early in an economic recovery but are typically more likely to lag in a sustained bull market
With long-term investing, some prefer to combine growth and value stocks or funds for the potential of higher returns with less risk. This approach allows investors to, in theory, gain throughout economic cycles in which the general market situations favor either the growth or value investment style, smoothing any returns over time – which is essentially a form of diversification.
Trading
Trading is the buying and selling of financial assets in any financial market, for oneself or on behalf of another person or institution. The main difference between a trader and an investor is the duration for which the person holds the asset. Investors tend to have a longer-term time horizon, while traders tend to hold assets for shorter periods of time to capitalize on short-term trends.
The objective of a trader is to make a return on their buying and selling of assets over a very short time period. Whereas investors will look to hold assets, for many years sometimes, traders will only be holding assets for a very short time relatively speaking, looking to turn a quick profit.
Different Trading Strategies
There are different types of trading that traders engage in depending on how frequently they trade. These are termed differently, depending on how long they hold their positions, from scalping or high-frequency trading (HFT) where traders hold their positions for as little as fractions of seconds, to position traders who might hold their position for years.
Even though being a successful trader is difficult to achieve, and often requires a lot of analysis to beat the market, as with investing, we don’t only see professionals engaging in trading (institutional investors). Since a lot of markets and trading platforms are highly accessible, amateur traders from the general public (retail investors) constitute most of the market, in terms of users, even if most of the funds being exchanged is from professional firms working on behalf of high net-worth individuals (and often themselves).
Where, What, and How Traders Trade
Traders operate in various ways trading a variety of financial instruments/assets. Here, they buy and sell shares in various public companies with one-another. Some trading markets are more accessible than others as we will discuss below.
Stock Market
The stock markets is where traders buy and sell shares from public companies. These markets are very common with retail investors as they are very readily accessible to most. Almost anyone can sign up at trading platforms and very quickly begin trading. The New York Stock Exchange (NYSE) is comfortably the largest stock market in the world, followed by the Nasdaq index and the Japan Exchange Group. The current market value of these indices are $28.19 trillion, $12.98 trillion, and $5.37 trillion respectively. Some of the more popular trading platforms are Merrill Edge and Fidelity Investments
Forex (FX) Market
The Foreign Exchange market, or FX market, is where currencies are traded across the world. Since it operates over multiple time-zones, it never closes. It is popular due to it being the most liquid market whilst also being the largest financial market in the world. According to Nasdaq, an average of more than $5 trillion dollars are traded every day through the FX market, which is more than 25 times that of the global equities market. CMC Markets, London Capital Group (LCG) and Saxo Capital Markets are among the most popular Forex trading platforms. The most traded currency is by far the United States Dollar (USD). The USD acts are the primary reserve currency for the majority of banks across the world. The average trading volume for the USD comes in at around $2.2 trillion per day. The Euro (EUR) follows from a (very) distant second place with an average daily trading volume of $800 million whilst also is estimated to account for 20% of global reserves by volume. The third most traded currency is the Japanese Yen (JPY), which makes up roughly 5% of global reserves, with an average daily trading volume of around $550 million.
Crypto-asset/Digital Asset Exchanges
A digital assets exchange (DAX) or Digital currency exchange (DCE) is a platform that allows its users to trade digital assets against other digital assets, or against fiat currencies (which can be considered digital assets). Often, people register with the intent of trading cryptocurrencies, and with the advent of Bitcoin, and other successful cryptocurrencies such as Ethereum and Ripple, exchanges that facilitate these kind of trades have become increasingly popular. Like with stock exchange platforms, and Forex platforms, most people are eligible to trade and registration/verification is relatively simple.
Conclusion
Investing and trading do have similarities and parts of their definitions can overlap, but there are important differences. For most people, investing is always a good idea. As long as you diversify sufficiently and never risk more than you’re willing to lose, the gains can be modestly attractive, whilst also being somewhat passive – depending on which investment style you prefer, of course.
With trading, it’s important to know that for the vast majority of people, this will be a speculative, high-risk, high-reward endeavor, especially with higher frequency trading. Therefore, for the more risk-averse individuals, it’s recommended to invest your money in something safe and reliable, such as bonds or real estate. For those more willing to take risk, or even just prefer more of a thrill and want a more hands-on, aggressive approach, trading has a lot to offer.
The important thing to remember in both cases, is to never risk more than you’re willing to lose, do adequate research into the field, and hone your skills over time. Becoming financially literate before even considering investing or trading is the best thing anyone can do; Benjamin Franklin famously said “An investment in knowledge pays the best interest.”. Doing this is the surest path to a successful and fulfilling career in the world of finance.
Disclaimer
This is not financial advice. Mentioning investment classes, coins and tokens is not a recommendation to buy, sell, or participate in the associated network. We would like to encourage you to do your own research and invest at your own risk.
