Is it better to trade or invest in stocks? What is the difference between investing and trading? Trading and investing are entirely different ballgames. Both have the same aim, to grow your wealth, but they have various time commitments, risk profiles, and likely outcomes. In this article, we explain the main differences between trading and investing, and hopefully, this explains what would be the best approach for you: What is trading? What is investing? Trading or investing – what is best?
Trading offers a very scalable career, while investing offers lower risk and less scale. Short-term trading requires excellence, while long-term investing only requires average abilities to succeed. What is best for you depends ultimately on your goals and personality.
Both trading and investing aim for good risk-adjusted long-term returns. However, trading involves doing many trades to generate small returns per trade but done many times, while investing is about letting your capital compound by making very few trades. Even if you are a below-average long-term investor, you end up wealthy by saving and compounding (if history repeats itself).
Most short-term traders would be better off if they invested their capital in stocks, mutual funds, and ETFs, and let it compound over time. If you still want to become a short-term trader, we believe you stand much better odds of success if you develop a portfolio of quantified strategies.
Trading has been around for centuries, but it tends to increase at the end of a bull market. Since Covid-19 in March 2020, we have witnessed spectacular gains in the stock market, and social media is full of people making “easy” money.
Trading and investing defined
In this article, trading is defined as profiting (or losing) from short-term market movements. The time frame is anytime from seconds to a few months.
Investing is an entirely different game. You buy and wait patiently for your holdings to appreciate. Most long-term investors invest in stocks, ETFs, and mutual funds to benefit from the tailwind of earnings growth and inflation.
Trading and investing – the main differences
The stock market has risen 6-10% in most Western markets over the last century. Unless something flamboyant happens, like, for example, a revolution, it seems likely to continue.
If so, why try to time markets by buying and selling? There are many reasons why someone would trade and not invest:
Trading vs. investing: trading is more scalable than investing
Short-term trading is, at least for small individual traders, scalable. If you find profitable strategies, you can build scale via automation or increased size via leverage.
Assuming you are a small trader, you can easily double your positions. At the same time, you can add an almost infinite number of systems as long as you trade automatically using a trading platform like, for example, Amibroker or Tradestation.
Trading vs investing: Traders want a steady return, not random rewards
Long-term investing requires you to tolerate huge drawdowns. In the GFC in 2008/09 the S&P 500 fell by 55%, and many thought the whole financial system was on the brink of collapse. In hindsight, it was an extraordinary buying opportunity, but remember that the market was substantially lower than in 2000. Pulling the trigger in the middle of all this negativity was challenging. The price you are paying for long-term gains is to accept these drawdowns. No pain, no gain.
Trading aims to make money no matter where the stock market goes. You aim for absolute returns, not relative returns.
I was day trading stocks on the NYSE and Nasdaq during the GFC, and 2008 was, by far, my best year, with only nine losing days out of 253. Below is my profit and loss diagram for 2008:
My returns were entirely uncorrelated for the market without holding any positions overnight (I traded stocks only, on average, over 100 different tickers per day – no indices). Every morning I started with a clean sheet. The magic behind the uncorrelated returns was volatility and automation. Also, most gains came from the long side, not short selling. We have very powerful bear market rallies in a bear market, which we documented in an article called the anatomy of a bear market.
Most people prefer steady gains over lump-sum rewards. This makes trading attractive.
The stock market can go sideways for many years, even decades. The zero return offered in stocks from 2000 until 2010 is already long forgotten. Many investors probably don’t realize that zero or even negative interest rates are discounted far into the future. We suspect the returns over the next decade are both a negative surprise and disappointment for many.
Trading vs. investing: Trading involves leverage, investing not
If the drawdown is low, you can use leverage to boost returns. However, leverage is often the downfall of most traders when you get run over by a “black swan”. Be careful.
Trading vs. investing: Trading equals action and excitement, investing is “boring”
Let’s admit it: trading is exciting and addictive. Long-term investing is mainly about holding your assets and waiting for appreciation, which is not very exciting.
Trading vs investing: Trading offers a faster way to wealth – get rich in a hurry
Because trading is scalable and allows you to turn around your capital frequently, you can get wealthy much faster than by long-term investing (see more about compounding below).
Skills required for success in trading
Trading is a zero-sum game. On any random trade, the expected return is pretty close to zero. To win, you need to develop trading edges that let you either win more often than lose or make bigger profits on winning trades than losing trades.
If you backtest and diversify to trade many uncorrelated strategies, you increase your odds massively, even though past results do not guarantee future success.
Thus, you don’t succeed by being average. Trading requires “greatness”. Below are a few factors you need to consider before you start:
- You need a passion for trading
- You need many strategies in different markets and time frames
- You need to overcome behavioral biases
- You need to learn how to program/code
- You need discipline and good work ethics
- You are forced to pay taxes on annual profits
- Trading is stressful
- Trading requires constant work, which, of course, has an opportunity cost
- You’ll most likely have long periods with no or negative returns
- You need a Plan B at all times
As a trader, you must adapt and learn faster than your competition. A high IQ is not necessarily an advantage. For example, the wiser you are, the better you are to find numbers and opinions supporting your theories and beliefs. An average IQ beats someone with an IQ of 140 but with a rigid mindset. We believe you stand a much better chance the more street smart you are – not book-smart.
Because most people get less prone to change habits the older they get, you are fighting against human nature. It’s more important to be adaptable and flexible than to solve complex problems. Markets change, and you always need to be at the forefront.
Jeff Bezos once said that if you double your number of experiments, you double your inventiveness. What does this mean for a trader? You must always test ideas and hypotheses and never be afraid of testing “stupid” ideas. Nothing lasts forever, and indeed not trading strategies.
Skills required for success in investing
The good is mostly in the absence of the bad.
The quote sums up the most critical factor for being a successful long-term investor. The easier you make it, the better you do (for most people). Why is that?
Investing requires no “greatness” – it’s more about avoiding unforced errors. You beat most money managers by aiming for average.
How is this possible? The majority of professional money managers fail to beat the averages over time. You beat professional money managers by investing in a basket of passive ETFs and mutual funds. However, we believe it’s a good idea to diversify into passive and active funds.
Long-term investing depends on how much you save and invest, the return, and the time spent in the markets.
Even being below average ensures you are reasonably wealthy as long you are patient and let your capital compound.
One hundred invested today grows to 1 750 in 30 years with a 10% annual return. Even a much worse return of 8% ends up with a ten-bagger (1 000). You’ll have to be a very successful trader to accomplish these returns. The difference between 10 and 8% returns grows over time, but the overall returns are enormous:
Perhaps you have to pay for your kids, wife, and mortgage. What happens if you don’t start saving early? Let’s use two examples to show the difference:
- You invest 10 000 at the end of every year for the next 30 years at a 10% annual return.
- You invest 10 000 in year one, but nothing in the next ten years. After ten years, you regain control of your finances and invest 15 250 annually for the next 19 years, thus saving an equal amount as in the first example (300 000). But you are fortunate with your timing and manage a 12% return in the last 20 years, not 10% as in the first example.
The returns of the two examples are displayed like this:
The blue bars are example one, and the red bars are example two. The increased return in example two can’t compensate for the lack of savings during the first ten years. It would help if you had more years to recover the savings gap or higher returns (which is unlikely as 12% is already significantly higher than the historical returns).
The lesson is simple: Start saving and investing as early as possible. Small monthly savings add up over time.
Women have proven to be better investors than men. Women are successful because they are not trying to outsmart the market. They save, invest, and forget about it.
The most basic requirement for an investor is to sit on your ass, as Charlie Munger likes to say. You’ll “win” by waiting longer than your competition. The returns might fluctuate and be uncertain in the short run, but the odds improve in the long run.
In investing, you have two tailwinds: earnings growth and inflation. So how do you go about becoming wealthy by long-term investing?
- Make sure you save and invest regularly, preferably once a month. Just a tiny part of your monthly income compounds over time.
- The earlier you start, the better. It’s much better to save a little earlier than later.
- Don’t outsmart the market: invest in several broad-based mutual funds and ETFs. Some with an active mandate, some passive. Be careful about investing directly in stocks. Most retail investors perform poorly.
- Beware the switches! Save and forget about it. Don’t buy and sell your holdings, unless necessary.
- Invest via a tax-deferred account. Taxes are a significant drag on your compounding.
- Don’t follow the financial news. You are more likely to make behavioral mistakes the more you follow the markets.
This is all there is to it. Nothing fancy. The easier you make it, the better you’ll do.
One famous Norwegian real estate investor once said that even lobotomized people could make money in real estate. To a certain degree, this is true in any form of long-term investing as long as you’re diversified, unleveraged, and patient.
The skillsets between trading and investing are different:
As you can see from the two skillsets above, many skillsets need to align to be a successful short-term trader. Do yourself a favor and consider the pros and cons before you start.
Traders use quantified strategies, investors less so
If you still want to become a trader, how do you increase your chances of success? My own anecdotal experience tells me you are better off by trading systematically. A mindset devoted to probabilities and the law of big numbers increases your chances of success.
In essence, you develop ideas and hypotheses that you code when to enter the trade, what position size, the direction of the trade, and when to exit. The complexity varies, but the ones with the most straightforward conditions often turn out to be the best.
You start with a simple idea, for example, what happens to the S&P 500 when it sets a five-day low? What is the average return over the next x days? What happens over the next ten days when the 15-day RSI is below 30?
I stress the importance of automation that makes you trade tens, if not hundreds, of different strategies over a wide range of markets and time frames. As a discretionary trader, you can only handle a limited number of systems. Moreover, you have no idea how to determine what you do wrong if you do poorly.
The downside is that automation takes time to learn. I believe taking a trading course will speed up your learning. Moreover, talking to traders who have succeeded pays itself many times over.
Alternatively, you can subscribe to the monthly Trading Edges I publish with my partner Hakan for a small fee:
Trading requires self-control – trading less so
An enormous amount of empirical evidence from online brokers indicates frequent traders underperform those buying and selling infrequently. In a recent study by Charline Uhr, Andreas Hackethal, and Steffen Meyer called Smoking Hot Portfolios? Self-Control and Investor Decisions, most of the above claims are empirically tested. The writers originally looked at the performance between smokers and non-smokers, but the takeaway is the following:
- Non-smokers obtained better results than non-smokers.
- Non-smokers were more diversified.
- Non-smokers traded less frequently.
- Non-smokers were less confident.
Why is this? As always, with empirical research, we need to be cautious when making conclusions. Cause and effect are usually a bit more complicated than simple regressions indicate.
This is what the authors write:
Smoking as a proxy for self-control failure is associated with a higher number of trades per month, higher trading volume, and higher portfolio turnover and not explained by other biases such as overconfidence, social contagion, sensation seeking, or attention grabbing. But we find that self-control failure exacerbates these other biases. We show that self-control failure is costly because it increases the gap between the gross and net returns of smokers relative to nonsmokers.
The authors conclude that when left to their own devices, smokers are worse investors than non-smokers because smokers lack self-control. Smokers are aware of their limitations and as a result of this, they tend to seek advice, either via an advisor, or they invest more often in mutual funds than non-smokers. Self-directed traders, more common among non-smokers, perform worse than funds, as well documented in other research.
The above is why you should consider your alternatives before starting to trade. Most short-term traders fail, while most unleveraged investors prosper.
Can you be both a trader and investor?
Trading or investing? You can both invest and trade!
No matter what you do, make sure you save and invest regularly in the stock market for long-term appreciation. Many short-term traders go bust, and investing is a safety valve.
Conclusion: Is it better to trade or invest in stocks?
After reading this article we hope you understand trading and investing and what is best. The two types of investing require different skill sets, and the differences are so significant we can argue it’s two different games.
Trading and investing require two different skill sets. You can get rich investing by being average if you are patient and avoid the gravest mistakes, but short-term trading requires that you are above average in what you do. However, we believe trading and investing can complement each other.
If you want to become a trader, please ensure you know all the obstacles you must overcome to succeed. Not only do you need to be good at trading, but you also have to be great at trading to make it worthwhile, considering the opportunity costs.
The safest and easiest way to make money is by long-term investing. You don’t need specific skills to succeed; you come a long way by eliminating the most obvious mistakes.
Trading or investing – what is best? Only you can decide that, but hopefully, you will understand better after reading this article.
– Is trading or investing better for scalability?
Trading offers a more scalable career, allowing for increased size through automation and leverage. Investing, on the other hand, typically involves lower risk and less scalability.
– What are the main differences between short-term trading and long-term investing?
Short-term trading requires excellence, many trades, and is more scalable, while long-term investing demands patience, enduring drawdowns, and relies on the tailwind of earnings growth and inflation.
– Why do traders prefer steady returns over lump-sum rewards?
Steady gains are preferred in trading for consistency and to avoid the emotional impact of market volatility. This makes trading more attractive to those seeking a reliable income.