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Differences Between Trading and Investing

A lot of time people mix up trading and investing in the stock markets. In fact, many a times retail investors aren't even aware if they are investing or trading a stock.

There is a basic difference between the two. What is it? Before getting to that, first let us try and understand what is investing and trading separately and then try and understand the difference between the two.

Investing

To put it simply, Investing is owning a piece of the business. When you're purchasing a stock as an investor, you're not buying a piece of paper. You are buying a stake in the business.

Imagine you are running your own business. What factors would you look at to see if your business is doing well?

  • Is the business giving me enough return based on the money that I have invested in the business?
  • Is the business growing steadily every year?
  • Am I able to collect cash from my customers in time to pay back my suppliers and purchase more goods to sell?

These are the same questions an investor should ask when investing in any stock.

An investor always thinks like a business owner.

Will a businessman think of closing down his business if profits are down for 3 to 6 months or a year? He most likely won't. The same way an investor thinks long-term about the stocks he owns. Few quarters of bad results won't force him to sell his stock.

Investing is all about looking at the fundamental aspects of a stock and then deciding if that stock is worth buying or not.

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Here are a few key pointers to look at while investing:

  1. Return on Equity (ROE) - This might be the most important factor when looking to invest in any stock. ROE simply answers the question: Is the business generating enough return based on the money invested. An ROE of 15% or higher is a good benchmark for any business.
  2. Moat - Does the business have a moat? Moat is any advantage the business possesses that prevents competition from entering and taking away market share. A moat can be in the form of a brand (Nestle, HUL), low cost advantage (Dmart), customer switching costs (Apple). The stronger the moat, the longer the business will perform well.
  3. Working capital position - This will answer the question of how well the business dynamics are and how well is it managed. Working capital simply means the days you receive your payments from customers, days it is tied up in inventory and the days it takes to pay your suppliers. The lower the working capital cycle, the better your business is managed.
  4. Cashflows - This ties up with the earlier working capital cycle metric. The better your working capital cycle, the better will be your cashflows. The better your cashflows, the better you will be able to manage your business. Your cashflows (operating cashflows) should closely match the net profits the business earns. That is a sign of a healthy business.

    Another important metric to track is free cashflows (FCF). Free cashflows is simply operating cashflows (CFO) minus the capital expenditures for your business. Consistent FCF implies a fundamentally strong business.
  5. Management - A competent and ethical management is the key behind any business. A poor management can destroy even a great business. On the other hand, a great management can run the ship steadily for decades and grow shareholder wealth. Capital allocation decisions, remuneration taken are some key pointers to look at when evaluating managements.
  6. Valuation - Finally, how much you pay for the business will eventually determine how much return you get from the business. Even a great business bought at an expensive price can give poor returns in the long run. An investor should always look to buy high quality businesses at reasonable or fair prices.

The video below will help you understand more about investing...

Let's look at the other end of the spectrum

Trading

Trading is simply buying a stock based on price. Here, the fundamental aspects of the business are not considered. Traders simply think in price terms. The judgment is simply based on human behavior related to stock price movements. A trader tries to predict how the stock price will move based on the collective action of multiple other players in the market.

Traders try to look at patterns from history to predict future movements in the stock price.

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Unlike investors, moat, ROE etc of a business does not matter to traders. Instead, a trader's main tools are technical charts to identify price patterns. Few indicators a trader looks at are 50 or 200 dma (daily moving average of stock price), volumes in a stock to gauge supply and demand or any short-term event coming up related to the stock.

While investing and trading are like chalk and cheese, there have been recent attempts to get the best of both worlds in the stock markets.

Marrying the two, the 'what to buy' part is answered through fundamental analysis. On the other hand, the 'when to buy' part is answered through technical analysis.

There is some merit in this approach. It might be useful in volatile markets where technical analysis might help you time your entry and exit better.

On the other hand, it might also result in confusion for investors and defeat the very purpose of investing i.e. holding stocks for the long-term and treating it like a business.

Differences Based on Risks Involved

Trading by nature involves more risk due to shorter time horizon. It involves predicting market movements over few hours, days or months, which is unpredictable. Although risks are high, successful traders also earn higher returns due to the volatile nature of the markets in the short-term.

Investing on other hand tends to be less risky if done over the long-term. Although returns gained through investing might seem lower than trading, the power of compounding and higher probability of success makes up for the relatively lower rate of returns.

Differences Based on Time Horizon

Traders mostly look at holding stocks for the short term. The time horizon can either be months, weeks, days or even few hours. A trader's job is to predict market or stock movements over short-time periods.

Investing on the other hand is a long-term game. It ranges from 3 years or more and the holding period can even be for decades. The basic idea is to stay invested in a business through its ups and downs and let it create value for shareholders in the long run.

What is Better Suited for a Retail Investor?

Trading involves a lot of activity and constant tracking of price movements. A trader normally has to be fully involved with the happenings of a stock market on a daily basis.

For majority of retail investors though, investing is about using savings to get a reasonable rate of return for investment in stock markets. Also, a retail investor might have a day job leaving limited time for him to dedicate to the markets on a daily basis.

Also, long-term investing is less likely to be volatile than trading and might suit the average retail investor.

Considering all these factors, it makes sense for a retail investor to follow the investing approach.

Overall, an individual should follow that he/she is comfortable with and also one that helps them get the best results from the stock market.

Recommended readings on Difference between Investing and trading:

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