The difference between investing and trading may not be immediately obvious, even for those who are seasoned market players. This is especially so if they choose to employ both strategies for different investment goals. While both investing and trading are geared at growing your wealth through the financial markets, the mindset and commitment for the two strategies differ. Let’s break down the differences.
Investing vs Trading
Investments are often held for a period of years — even decades — taking advantage of investment gains that include capital appreciation, dividend payouts (passive income in a way), and/or stock splits along the way that lift the share valuations.
The aim of investment is to gradually build wealth over an extended period of time, by buying and holding a portfolio of stocks or other asset classes.
Trading, on the other hand, involves more frequent transactions. Those with a trading mindset often believe that the markets are inefficient and that they are able to identify market mispricing to make higher returns. It aims to generate quicker returns that outperform the buy-and-hold investing strategy. The differences in investment strategies are summarised below:
Why passive investing works better for you
Better performance — in the long run
Just by performance results alone, passive investing works better for most investors. You might think that a professional investor would beat an index fund. Yet in reports by Morningstar and S&P Global, only 11% of actively managed large-cap equity funds outperformed their passive peers over 10 years. To add, 4 in 10 of all large-cap funds fail over a 10-year period, reflecting the poor stock-pick decisions made by fund managers that resulted in fund closures. This shows that active traders do not necessarily outperform even in times of volatility that supposedly favours them.
Lower fees
Even if active trading outperforms passive investors, transaction costs eat into investment returns. The most obvious transaction cost is trading commissions, which are fees paid for handling the buying or selling of securities. Active trading is generally more expensive as more transactions are made. Many active traders fail to outperform passive investors after accounting for these fees.
Shorter time commitment
For passive investors, since investments are over a longer time horizon, you are better able to take on some level of risks and take your eyes and mind off the market as it rides through various market conditions. This frees up time for your other obligations.
Frequent trading reduces profits
Since you need not monitor the market closely as a passive investor with long-term goals, you will not be as affected by minor and intermediate market movements resulting in exercising more trades. History has shown that the stock market has stood firm against big market crashes and remained resilient against volatility over the years. Therefore, the buy-and-hold strategy works out for passive investors.
A study by Terrence Odean, known for his work on behavioural finance, also shows that on top of higher fees, conducting frequent trades would reduce profit-making due to its psychological effects. When your emotions are easily swayed by market performance, your judgments become clouded and become more prone to making impulsive decisions — like betting on the prices going up or down based on speculations. Overconfidence make you think you can beat the market. It is a common behaviour that encourages more active trading resulting in earning less, and under diversifying.
Risks of a trading mindset
Other than considering the upside of passive investing, risks involved in trading should prompt caution in active trading.
Wallstreetbets and meme stocks
The GameStop saga in 2021 unleashed the trend of meme stocks, which are counters that gained popularity on social media. This process set off the popularity of investment slang words and phrases such as “Stonks”, “to the moon” and “r/wallstreetbets”. (Stonks is a deliberate misspelling of stock to imply a poor investment decision resulting in financial losses). If you see a rocket emoji or users commenting “to the moon”, it means that they believe the stock will see a big price increase.
R/wallstreetbets, meanwhile, is a subreddit page for users to discuss stocks and other investment related topics. Users on r/wallstreetbets lapped up the GameStop stock in particular, sending it to soaring prices, and seeing it crash in dramatic fashion. This period of tremendous gains and losses shows how volatile meme stocks are. Just imagine going away for a 30-minute meeting, and coming back to see the investment tumble 40%. The volatility of such stocks make them riskier than traditional investments.
Adding to the GameStop saga, non-fungible tokens (NFTs) gained mainstream popularity late last year with new NFT projects placing ads all over Hong Kong every few days, though in 2022, that FOMO trading has somewhat washed out.
FOMO in trading
“FOMO” is a slang word that stands for “fear of missing out”. FOMO in trading essentially means that you do not want to miss out on taking profits when others are in on it. Watching others take lots of profit from a single stock makes you want to join in and take a piece of that action. Even if your mind tells you that the biggest profit has already been taken, you feel obligated to join in on a “winning” stock without doing your due diligence in researching. FOMO in trading often leads investors to make uncalculated and riskier decisions than they otherwise might avoid under calmer circumstances.
The dangers of FOMO in trading surfaces when you start to question your investment strategy and affect your decision making, eventually derailing your investment plan.
Having an investment plan to reach your financial goals is often a long-term pursuit. A get-rich-quick strategy rarely works. Instead of speculating and chasing the next meme stock, resisting the temptation to react to the ups and downs of the stock market in a disciplined way makes for a better investment practice.
When trading is disguised as investing
Although it is easy for experienced investors to understand and appreciate that trading is time-consuming and unlikely to give consistent high returns, many investors may still unintentionally time the market or panic-sell their investments during periods of high volatility.
Some common justification these investors have included:
- “The market is high now, I think it is a good time to take some profits and go in when the market stabilises.”
- “I believe Chinese technology has a strong chance of outperformance after the recent sell-down, so I should allocate most of my money into the sector to get higher returns.”
Investing consistently requires self-discipline and self-awareness to identify and rectify trading tendencies when they bubble to the surface. If you believe that the financial markets are efficient and you cannot time the market, it is best to automate your investments as much as possible. This includes transferring your cash into your account, and setting up a recurring investment goal.
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Risk Warnings
Investment involves risk. Past performance is not an indicator nor a guarantee of future performance. The value of investments and the income from them can go down as well as up, and you may not get the full amount you invested.
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