Trading vs Investing: How To Choose The Best Approach

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When it comes to making money from financial markets, trading and investing seem like interchangeable words. The reality is that they are distinct from each other. Each option comes with its own set of benefits and potential risks. 

Individuals and companies today have many ways to capitalize on market movements. The two primary approaches dominating the landscape are trading and investing. While traders and investors seek to profit through market participation, their methodologies differ significantly. 

Traders take advantage of the market rises and falls to enter and exit positions. They do this within a shorter time frame, aiming to take more frequent but smaller profits. Investors, on the other hand, have a different time frame from traders. They generally seek more significant returns over a more extended period. Such returns are accomplished through buying and holding assets or securities. 

Here, we will dive deep into the principles behind trading and investing. We then explore the strategies associated with each. Knowing the intricacies of both approaches provides better insight and will help you determine which is best for your financial situation and goals. 

What is trading?

Trading is an active approach to financial markets. It involves more frequent transactions and a shorter-term horizon. Frequent transactions include buying and selling currencies, stocks, derivatives, commodities, and other financial instruments. 

As a trader, you aspire to generate returns that outperform the buy-and-hold approach of investing. You do this within a time frame of seconds to weeks. You would focus on capitalizing on market volatility and short-term movements to generate quick returns. 

For example, a trader would seek approximately 10 percent in returns monthly. By contrast, those who choose the investment approach would be happy with a 10 to 15 percent annual return. Such profits are possible by buying instruments at a lower price and selling them higher in a time frame that is relatively shorter than that of investing. 

It is also possible to profit from trading by selling high and buying low—an approach known as short-selling. Selling short is a way of profiting from falling markets. 

Traders have many strategies in their toolkit to quickly profit while mitigating risk. Traditional buy-and-hold investors wait out less profitable positions. On the other hand, traders profit within shorter periods but use a stop-loss order to protect themselves. Stop-loss orders automatically close out losing positions at predetermined price levels.

Another popular tool among traders is technical analysis (TA). To identify high-probability trading setups, they employ stochastic oscillators and moving averages. 

Different trading styles

Trading styles refer to the holding period when a stock, derivative, commodity, currency, or another trading instrument will be bought and sold. Depending on their account size, time dedicated to trading, level of experience, risk tolerance, and personality, traders generally adopt one of the following styles:

Day trading

A day trader holds a position within a single trading day and has no overnight positions to prevent exposure to market risk. They depend on charts, indicators, and TA to decide their trades.

Position trading

Position traders hold their positions from months to years. 

Swing trading 

Swing traders hold their positions from days to weeks. This time frame aims to capture price swings within a trend.

Scalping or scalp trading

A scalp trader holds a position from seconds to minutes. Scalpers make numerous small daily trades and do not hold overnight positions. They aim to make money from small price fluctuations. Scalping entails focusing on tight spreads and requires the ability to make lightning-fast decisions. 

Automated or algorithmic trading

Algorithmic trading relies on software. Computer algorithms are programmed to execute a trade based on predetermined criteria. You can apply this automated type of trading to various strategies and timelines. 

Strategies in trading

Traders don't only have preferred styles; they also have other means to profit from markets. Trading strategies are systematic methodologies used to buy and sell securities in the markets. These strategies are formulated on predefined criteria or rules, which are used as frameworks for trading decisions.

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Such strategies may be simplified and distilled or complex. They may consider factors such as market cap, technical indicators, personal investment style, level of desired portfolio diversification, risk tolerance, tax issues, leverage, sector or industry, holding period or time horizon, and many others. 

A trading strategy involves a carefully considered trading plan with specifications. Traders must research best practices and plan for each instrument, such as bonds, ETFs, or stocks. More complex trades may take the form of futures or options.

When you place a trade, you work with a broker or broker-dealer. You actively identify and manage costs and must be keenly aware of fees, spreads, and commissions. 

Once trading positions are executed, they are closely monitored and managed. These positions are adjusted or closed as necessary. Traders measure risk and return and gauge the impact of these trades on their taxes and portfolios. 

No matter what the basis, the trading strategy must be solidly based on objective data and analysis. Moreover, traders must adhere to it diligently. Even so, traders must re-evaluate their trading strategies periodically to adapt to goals and market conditions. 

Preferred time horizon

Traders employ a short-term outlook or horizon when performing trades. As a result, traders monitor markets constantly. They track shifts in asset prices and quickly make moves. Traders aim to use the market's ups and downs to maximize profits and avoid losses. As described under trading styles, the time horizon can range from seconds or minutes to days or weeks. 

How To Choose a Trading Strategy

There are several types of trading strategies, and each is based on using either fundamentals or technicals. Such techniques have one thing in common—they rely on quantifiable information. You should backtest such information for accuracy.

Fundamental trading strategies involve the consideration of fundamental factors. Investors have screening criteria used to generate a list of opportunities. Such criteria are developed by analyzing various factors, including profitability and revenue growth. 

As the name indicates, technical trading relies on technical indicators to generate the correct trading signals. Technical traders believe that all the information about a security lies in its price. They also believe that security moves in trends. Some trading strategies may involve moving average crossovers wherein short-term moving averages cross above or below long-term moving averages. 

It is complex to develop profitable trading strategies. Many consider it quite tricky. Such methods are used to avoid behavioral finance biases and guarantee consistency of results. The traders who follow rules of when to exit a trade employ this for discipline—to avoid succumbing to the disposition effect. 

The disposition effect causes investors to keep holding on to securities that have long lost their value and sell those that have risen in value. It is possible to stress-test trading strategies to measure the consistency variable applied under shifting market conditions. 

Even as technical traders believe they rely on math and other empirical bases, they risk becoming over-reliant on a particular strategy. They could be vulnerable to false confidence, such as curve fitting a trading strategy to specific backtesting data. 

Past performance does not necessarily ensure future success in real-time markets. The conditions of real-time markets may vary significantly from the test period when backtesting was performed.

What is investing?

Investors aim to build their wealth over an extended period. The idea is to build it gradually. Those who prefer the investment approach buy and hold a portfolio of a single or several asset classes. 

Investors may choose to invest in stocks, bonds, mutual funds, baskets of stocks, ETFs, or exchange-traded funds, and other instruments. With the popularity of online investing, investors today are better equipped to gather information about their financial decisions.

The time horizon for investing is between years or decades. Along the way, investors hope to take advantage of perks like stock splits, interest, and dividends. Investors understand that markets fluctuate—this is an inevitability. 

However, their long-term perspective helps them ride out the numerous downtrends in the cycles. Eventually, prices are expected to rebound. The time horizon, therefore, shields them from short-term losses. Investors look at P/E or price-to-earnings ratios, management forecasts, and market fundamentals.

You are already investing if you have an IRA (individual retirement account) or 401(k). These accounts don't require you to track your performance daily. The objective of retirement accounts is to grow money over decades. Therefore, daily fluctuations of various mutual funds are not a primary concern. Instead, the more important metric is their consistent growth over a long period. 

Styles of investing: Are you an active or passive investor?

There are two types of general investment approaches, and investors typically gravitate towards one or the other.

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Active investing

The active investment approach takes a more hands-on style and monitors markets regularly. They make changes accordingly based on their findings. Active investors always search for investments that mimic or outperform a specific benchmark index's returns. 

In addition, active investors tend to be busy at irregular or all hours, catching the best times for forex trading, choosing among New York, London, Tokyo, or Sydney sessions, and between busy and less volatile markets.  

Passive investing

The passive investment approach involves the buy-and-hold strategy. These investors do not regularly monitor the markets. Instead, passive investors aim to track the returns of the benchmark index. 

Similarities between investing and trading

Both investing and trading have the same end goal, which is to profit or make money. Investors and traders set up their accounts to buy and sell different access like stocks, mutual funds, bonds, ETFs, etc. 

Both investing and trading have their benefits, rewards, and risks. They have their pros and cons. There is no perfect approach to dealing with fickle and volatile markets and no perfect way of predicting the outcomes of trades and investments. Every asset has the potential for gains as well as losses.

Differences between trading and investing

The main difference between the two approaches is the length of time that the assets are held. Investors eye a longer time horizon for various reasons. Typically, they hold assets for over a year. Traders have a different outlook. They hold their assets for as little as seconds to minutes. 

Because of these differences in time horizon, the potential for loss is a crucial difference. You risk losing money in every situation, whether it's a longer or shorter period. 

However, traders have a more considerable risk for several reasons. The shorter holding period makes them vulnerable to timing mistakes, behavioral factors, and biases. Trades are also more open to holding a more diverse mix of assets, especially those investors avoid in their portfolios. Examples of such assets are swaps and futures. 

Trading requires a more intensive allocation of time and effort. It also entails a keen and in-depth understanding of the markets. Trading also requires you to conduct consistent research. Experienced traders develop a keen sense of how markets work. 

Beginners, however, do not yet have such instincts. Investors may have a different background than traders. And many investors rely on outside expertise and consultation to make their decisions. 

Which is more profitable, investing or trading?

There is no straightforward answer to this question. The answer depends on the individual or entity. It considers many factors, including financial situations, goals, resources, risk tolerance, time horizon, expertise and capability to navigate markets, availability, style, and so on.

Trading is better suited to those with a keen grasp of the markets and how they work. Trading also accommodates the risk-tolerant. 

Volatility and dips in the market won't easily faze those capable of handling higher risks. They are aware that losses are part of the game. The risk-averse are better off investing to mitigate risk and preserve capital. We can better compare the two based on a set of criteria.

Time commitment

Trading demands considerably more time and attention. There is no such thing as passive trading. As such, traders must monitor markets constantly and execute trades as needed. It is an approach that runs in real time.

On the other hand, investing requires far less attention as it doesn't need you to check on markets constantly. Hence, it is suitable for those with less time to devote to the markets and those with a longer time horizon.

Expertise and knowledge

You need a thorough understanding of technical analysis, risk management, and trends to trade successfully. You also require considerable experience in executing trades quickly. Investing is more focused on fundamentals—analyzing company valuations and intrinsic value. Thus, those who abide by this school of thought ought to choose to invest.

Psychology and behavior

The ups and downs of trading can be emotionally challenging. Experienced traders, for the most part, know how to separate emotions and reactions, but nothing is 100 percent. This feat is difficult for anyone, so one must be highly experienced and disciplined to circumvent hardwired instincts.

On the other hand, investing requires less vigilance and thus does not give rise to as much reactivity as trading. Hence, investors can withstand short-term dips because they have long-term goals.

Risk and reward

Both approaches have their benefits and downsides regarding risk and reward. Trading carries a higher risk overall because recovering from short-term crashes and cycles is difficult. There is simply not enough time to wait for the market to get back up. However, it has advantages, including the potential for substantial and quick profits when the opportunity presents itself.

Investing requires patience, as it takes years to realize rewards—however, the long-term horizon cushions investors from short-term volatility. 

Trading vs Investing: Is One Better Than The Other?

Understanding your approach is critical when it comes to profiting from the markets. While investing and trading have similarities, their differences define your choice. 

Overall, trading is the riskier choice because it involves much speculation and usually requires higher liquidity. Also, traders need more complex skills to navigate the markets and understand how assets work. 

Traders must also monitor the charts constantly, time their trades properly, and buy and sell their assets regularly. They may take on complex instruments like swaps and futures contracts. 

Trading allows the use of margin—a loan offered by brokerages to traders, provided they agree to ante up their assets as collateral. As the potential for profits increases, so does the risk of loss. 

On the other hand, investing tends to suit those who are more risk-averse and prefer a longer time horizon. Such qualities in investors may protect them from impulsive decisions and having to ride volatility. 

The downside to investing is that it may generally yield less earnings on their portfolio. If they make 8 to 10 percent annually, a trader can cover that profit or more in as little as a month and end up with an even higher uncompounded annual return.

There is no single correct approach to the markets. Weigh the advantages and disadvantages, factor in your financial goals, and ultimately use the strategy that works for you. 

This post was authored by an external contributor and does not represent Benzinga's opinions and has not been edited for content. The information contained above is provided for informational and educational purposes only, and nothing contained herein should be construed as investment advice. Benzinga does not make any recommendation to buy or sell any security or any representation about the financial condition of any company.