Differences Between Trading and Investing
Almost always, people understand the difference between trading and investing as involving differences in the duration of the investment, where investments are held longer term and trades are held for shorter periods.
This is generally the case, but there is more to it than just how long something is held, or the intention of how long the investment should likely be held.
Investments may involve specific durations, which may or may not be subject to performance considerations, and one may just choose to hold the investment for a given length of time regardless of where its price goes, or even how the outlook of the investment from a fundamental perspective may change.
As a general rule, positions that are held or intended to be held for several years or more are considered investments, where the investor is more invested in the position, so to speak. Trading involves taking positions that are shorter than a couple of years, where one intends to hold these trades from anywhere from mere seconds to a year or two generally.
There is no fine line that separates trading from investing per se, and there is also no set distinguishing characteristics that separate them either, for instance with one being based upon fundamentals and the other being driven by technical analysis.
Even long term investing can be driven purely by technical analysis, and one may also trade shorter term based upon fundamentals, although technical analysis does generally play more of a role with shorter term trading than it does with long term investing.
All investing involves trading, where one selects assets to take a position in, and then decides when to enter and exit trades in it, and this all involves trading decisions every step along the way. Once a position is entered, there is constant decision making involved as to whether the position should continue to be held or closed out.
The Weighting of Market Conditions
Whenever one enters a position, the initial decision will be whether to base one’s exit criteria upon market conditions or not. Those who choose to hold an asset for a given period of time, even if this time frame isn’t explicit, are choosing to let non market factors influence this decision, when one may need to cash in some or all of the investments to spend, or an age based strategy where one adapts one’s portfolio to where one is in one’s life cycle.
This need not be an all or nothing thing, as investors may still wish to override these intentions if market conditions dictate, and this leads to a hybrid strategy of sorts where investments are held for certain lengths of time provided conditions don’t deviate too much from expectations on the down side.
One may also choose to allow market conditions to completely dictate one’s strategy as far as the length of time investments are held, where the goal becomes to stay in positions as long as certain conditions are met, in other words as long as the expectations within one’s desired horizon stays positive enough to remain.
This probably defines trading as well as we could, where trading always involves basing one’s decisions on the expectations of the asset that is traded, as opposed to investing which imparts criteria that is not market based.
By this definition, one could trade even during long terms, where positions may be expected to average 10 years in length or more, with the only focus being whether or not one’s positions are performing well enough to continue to be held.
We could look at monthly charts of various assets and use indicators which can produce trading signals pretty easily that could have us entering and exiting this infrequently, and there is certainly a lot to be said about approaching investing with such a trading mentality.
Our own particular needs are irrelevant to the future expectations of anything, and ideally, we should always be using performance to guide all of our decisions regardless of how long our horizons for trades may be. If it turns out that we need to cash in a position at a less than ideal time, that will always be unfortunate, and while these things can happen, we ought to be doing our best to avoid this rather than making our needs a fundamental part of the strategy.
Why Do People Trade Rather Than Invest?
This principle of letting the expectations of the trade itself guide us is the fundamental basis of trading, or at least trading understood properly. We could take positions of shorter duration based upon fixed time criteria, to hold something for a year or a month or whatever where this time frame is imposed as a guiding principle, but doing so would not make much sense. It doesn’t make much sense to ever do this, although with investing we so often do.
We could call longer term trading purely based upon expectations investing, simply due to the expected length of time that the trades are to be held, like our example with the monthly bars. We can also use fundamental considerations such as economic indicators, interest rates, earning trends, or whatever we wish to guide us here, but the important part is to be purely focused on the changing environment and how this may influence future expectations, and this is what makes the approach trading
It should be obvious why this is a superior approach in itself compared to paying less attention or even none in a lot of cases to these changing conditions, as these are the conditions that influence the positions we are in, so we indeed need to pay attention to them.
The actual time frames that we select, with trading generally involving shorter time frames than investing, is actually a separate matter. Once that we’ve decided that we’re going to let the performance of the asset guide our decisions, both when to enter and when to exit, we then need to look at what time frames we wish to trade in and why.
Seeking to trade successfully involves looking to profit, as investing does, but trading seeks this profit efficiently. An example would be to look to time the trade according to probabilities based upon certain criteria versus allowing for extraneous data such as our own needs to influence it.
The goal is not only to seek out the most profit potential, it is also to do so while managing risk satisfactorily. Profit potential concerns the overall probability of certain trades and certain trading strategies, where risk management involves limiting probabilities of unacceptable losses.
Successful trading involves managing both, and risk management is at least as important, avoiding drawdowns that may overly affect us negatively. Investors generally do not pay anywhere near enough attention to risk, often not even having a good plan here other than some vague notions of when one may have had enough in a position, where with trading one focuses more on limiting the downside risk of positions and having a more active approach to limiting one’s losses in trades.
People therefore trade to make more profit and also to limit their losses more, and virtually all good traders will always have a stop loss in place with their trades, the maximum amount they are prepared to lose with the trade. Investors rarely use stop losses and this can result in losses mounting well beyond what should be accepted.
How Shorter Term Horizons Benefit Traders
The markets of financial assets are cyclical, with several trends of varying durations in operation simultaneously. The long term trend for something may be up for instance, if we look at it on a monthly chart, but the trend may be down on a weekly chart, up on a daily chart, down on an hourly chart, up on a 15 minute chart, and so on.
Deciding what time frame to trade in is certainly not a simple matter, but the first thing that one needs to understand is how different time frames affect our expectations.
Trading, or investing for that matter, is all about predicting the future, and to trade or invest well, we need to predict it well. Very long term investors predict that the price of their asset will go up over the long term enough to provide them with a good probable return for instance.
On the other end of the spectrum, computer trading involves trades that may only last for microseconds, and look to take advantage of the probability that these trades will be able to predict extremely small price fluctuations in a way that money can be made.
Both of these strategies can be used successfully, and the biggest differences between them is differences in efficiency and levels of risk per trade.
Shorter term timeframes tend to have a greater potential for efficiency than longer ones, all things being equal. An example would be the long term buy and hold approach, which may return a good amount in spite of all of the ups and downs of moving back and forth from bull to bear markets.
If a trader is able to successfully ride these bigger cycles, and be long during the bull markets and flat or short during the bear markets, this allows for a greater potential to profit, even though this does involve more skill of course.
This principle applies to all time frames, and one can seek to time trades during whatever duration one wishes, even using charts with 1 second increments or tick by tick. While shorter term trades do allow for more efficiency, there’s also the matter of increased trading costs due to trading more, as well as the potential to miss part of moves in your favor, and this needs to be accounted for when one chooses from among different time frames.
Shorter term trading also allows for better risk management in each trade, simply due to the fact that it will take a lesser move against you generally to exit a shorter term trade than a long one. Shorter term trading does expose the viability of your trading plan more than longer term trading does though.
If one places a single trade over one’s lifetime, they could get lucky and do well, but the more you trade, the less luck plays into things, as luck evens out. This is similar to making a bet where you could win even though the odds are against you, but if you bet enough you will lose all your money from these inferior odds exerting themselves.
So while shorter term horizons can be of benefit, this is only the case when you have a profitable edge, where this edge can be leveraged, but if you have a negative expectation with the strategy you are using, trading more often will simply accelerate your decline.
There is a lot of skill involved in trading, particularly with short term trading, and while few people may want to become short term traders, the principles and advantages of trading are ones that can benefit everyone looking to profit from financial markets provided they are understood and executed well.