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The Difference Between Trading and Investing

In a recent post, Chad at the Periodot Capitalist put up a post which talked about things in terms of trading and investing as separate operations. I am always curious to hear how folks differentiate the two, so I left a comment asking his opinion. He actually went so far as to write a whole new post on the subject: Differentiating Between Trading and Investing.

Chad starts off by expressing the view that he defines the difference basically the same way as everyone else, but that’s exactly why I asked the question. It’s been my experience that people have an array of views. In particular, a lot of folks I would call stock traders refer to themselves as investors. So when I hear someone say they are an investor, I try to get clarification.

Chad then goes on to define investing, as he sees it, in this way:

The main difference between “trading” and “investing” is time horizon. Investors are long term players. They are investing in a business and are making an optimistic bet about the fundamentals of that business in the future.

Personally, I don’t like the first part of that definition related to time, but I do like the latter part about the fundamentals of the business. I won’t make an issue of the fact that he used “investing” to define investing. 🙂

The reason I don’t like the time part of differentiating the two groups is because traders can just as easily hold positions in the long term as hold them for the short term. Similarly, investors can just as easily get out of a position in a couple of days as a couple of years. I will agree, though, that in most cases the anticipated holding period of an investor when entering a position is much longer than when a trader enters into one.

In The Essentials of Trading I talked about the difference as being mainly in terms of the exit plan. Traders generally have them going in, meaning they have a specific set of criteria which will trigger an exit – often something related to price action, but not always.

Investors, though, handle things a bit more nebulously. They will exit a position when the fundamentals no longer support their being long. That, however, isn’t something which can easily be defined since there are so many factors involved. It’s not usually as cut and dried as falling short on the latest quarter’s earnings.

Chad also differentiates traders and investors by saying the former don’t concern themselves with fundamentals. While certainly there are loads of traders who focus only on technical analysis methods, they are only part of the story.

For example, I consider myself generally a stock trader (though I do sometimes invest) because I enter positions with a specific exit plan, but that doesn’t mean I ignore the fundamentals. Quite the opposite, in fact. I will rarely trade a stock in which the fundamentals don’t back up my technical view. Also, some of my exit criteria are usually based on the fundamentals.

How do you define trading vs. investing? Leave a comment and let me know your views on the subject.

By John

Author of The Essentials of Trading

16 replies on “The Difference Between Trading and Investing”

I understand your point about traders calling themselves investors. I think they do this because anyone who buys a stock in the market technically is engaging in investing, so it’s really just semantics. Personally, I think traders are investing in “the stock” and investors are investing in “the business.”

Is there a difference? I think so. In the short term (most traders desired time horizon) the things that influence stock prices are usually (barring an earnings announcement or something like that) unrelated to the fundamentals of the business, i.e. market sentiment, momentum, technicals, media stories, money flows, etc.

Conversely, an investor generally has a long term time horizon intention. Typically, their argument for buying a stock will be valuation based (i.e. they think earnings can grow at “x” and the multiple on those earnings will be “y”, so the stock will appreciate to “z” over a certain time horizon). When their fair value target is reached, they sell and move on. I know of few traders who think in terms of fair value, earnings growth, or P/E and P/B multiples.

I disagree that investors do not have exit plans going in, but traders do. I think both sets of people have exit plans. However, as my post indicated, the criteria traders use (technically based) are usually different than those investors use (fundamentally based) and they usually have a differing expected time horizon for which those exit plans will hopefully be acted upon.

You can always find traders that hold stocks longer than they expected to and investors who cut their investment short, but I would argue the traders would do so because the technicals remained intact, whereas investors would do so because the fundamentals deteriorate, so the core factors differentiating the two groups still remain.

Anyway, always enjoy a good conversation, so thanks for commenting in the first place…

Interesting perspective on investing in a stock vs. investing in a company. I very much doubt that most of the folks who call themselves investors but are really traders (as we would define them) quite thinking at the at level, though. 🙂

In terms of traders looking at fundamental stuff, consider the slew of CANSLIM traders out there. And I think we would both call them traders since they are basically momentum players, and not long-term investors in companies.

On the exit plan, I shoud have stated things a bit differently. It’s not that investors don’t have an exit plan, it’s just a bit more open-ended from an immediate perspective. Basically, so long as the fundamentals are good – in the investor’s judgement – the position is held. Those fundamentals are generally slow to change, though, and the things which create that change are enormously varied so you would be hard pressed to cite a few specific and definite things which would immediately change your view.

If that makes any sense.

“Basically, so long as the fundamentals are good – in the investor’s judgement – the position is held.”

One should sell when they feel the stock is no longer undervalued. Stocks can have good fundamentals, but if they are fairly (or over) valued, there is no reason to hold them. I don’t think it’s open ended… you have an opinion on what fair value is, and reaching that level is the exit plan. Maybe other people don’t do that, but I’m not sure why they wouldn’t.

If you plan on making money by selling – EVER – you are a TRADER.

Even if it’s 25 years of holding.

Buying for dividends and holding bonds to maturity are about the only forms of “investing” in the financial markets.

Chad – I wouldn’t say “no longer undervalued”, because you could reasonably hold a fairly valued stock. That presumes the expectation for some rate of return. Obviously, overvalued is totally different.

That, in turn, ties in with what Bill brings up. If a stock never gets overvalued, then one would have no reason to sell.

John, I guess it depends on what your goal is. If you are not trying to outperform the market, then yes, I guess you would have no problem holding a fairly valued stock indefinitely. In that case it would closely track the market’s return, which would be positive over the long term. However, as a portfolio manager, I would have no reason to hold a fairly valued stock unless I couldn’t find a single stock I felt was undervalued.

As for Bill’s assertion that there is no difference between an investor and a trader, I don’t quite follow the logic.

Chad – Obviously you’re talking about risk adjust returns, since theoretically even fairly valued stocks could outperform the market, if they were riskier.

As for Bill, I get what he’s saying. I believe his point is that any effort to profit from price movement is speculating (trading) and not investing.

Chad, here’s the logic. Traders make money through buying and selling. Investors make money through buying a stream of income payments.

Therefore, if your plan is to buy for capital appreciation and a later sell, then regardless of timeframe, you’re a trader.

Chad – I think you’ll find that one used quite often in personal finance. Robert Kiyosaki (Rich Dad), among others, uses a definition like that. For example, in his way of viewing things, a home is not an investment because you actually have to pump money into it and the only way you get anything out is by selling at a higher price. That makes it an asset, whereas a rental property where you receive income would be an investment.

An asset is simply something you own that has tangible value. Both a home and a rental property would qualify.

If an investment requires an income stream without having to sell the asset, as you say, then how is the purchase of stock not an investment? If rental income qualifies, dividend income would have to as well, no?

I think Bill got it right. “Investors make money through buying a stream of income payments.” Suppose, you are an entrepreneur and you founded a new small company that is expected to fast in the next few years. The next year you sell the company to private investors. Are you trader or investor?

Chad – Bill included dividend paying stocks in his initial definition. The point, though, was that the stock was bought for the dividend. Capital appreciation, while a nice bonus, was not the main objective.

I’m not saying that I personally subscribe to this particular differentiation when speaking in terms of participation in the financial markets, but I do understand why it is used in the broader personal finance sense.

Well, I won’t keep going back and forth with you guys on this one, but as my last comment on the topic, keep in mind that common stock affords its owners a stream of cash flows generated by the company, divided up by proportional ownership.

Passive shareholders give the choice of how to allocate shareholder capital to the management team and the board. They can choose to pay it directly to shareholders via dividends or stock buybacks, or reinvest it back into the business if they find attractive projects. In any case, it is the shareholder’s money, and very similar to a rental property owner who might keep the rental income or reinvest it by buying another property.

While I disagree with these definitions (just because somebody like Kiyosaki makes up one on their own, I don’t think it means finance textbooks become outdated), but even if you accept the need for a stream of income, stocks provide that to their investors, they just hire someone else to decide how to allocate their capital for them.

Thanks for the discussion and take care, guys.

@ n2: judge by intent.

Did they build the business for the purpose of generating a stream of profits that they would live by? That’s clear-cut investing.

Did they build the business for the purpose of paying their salary and building equity that they would sell and retire with? Less clear-cut, but as a one-off, I would call it an investment.

Are they in the business of building businesses to sell? Did they build this one with the express idea that they would sell it (for some other reason than a “life change” like retirement? I would call that trading.

From what I have thought about the two, I think there is a very clear difference between the two that people should not be able to muddle with anyways. When you “invest” in something, there is an expectation of profits to come because you put up money to support something. however, trading is just buying and selling of goods with the intention of making a profit from the resale. or even from producing a good and selling it. i think that’s trading because when you are producing a good with the intention of selling it the production is a sort of “buying”, except that the cost is broken up into getting raw materials, paying the workers, etc. THIS can be separated easily from investing into a business of trading. Suppose A makes a toy factory. The making and selling of the dolls is trading. but the setting up of the factory is an investment into a business that will give profits.

Another way you might look at this is that the person running the business is trading while others putting money into it are only investing. but i don’t think that correct.

Let me know what you guys think of this.

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