Last Updated on March 6, 2021 by Oddmund Groette
Trading and investing are entirely different ballgames. Both have the same aims, to grow your wealth, but they have various time commitments, risk profiles, and outcomes. Trading has been around for centuries, but it tends to increase at the end of a bull market. Since the Covid-19 in March 2020, we have witnessed spectacular gains in the stock market, and social media is full of people making “easy” money.
This article looks at long-term investing and short-term trading and how likely you are to succeed in both.
Short-term trading requires excellence, while long-term investing only requires average abilities to succeed. Even if you are a below average long-term investor, you end up wealthy by saving and compounding. Most short-term traders would most likely 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 for success if you develop a portfolio of quantified strategies.
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 from earnings growth and inflation.
Why trade and not invest?
The stock market has risen between 6-10% in most Western markets over the last century. Unless something very dramatic happens, like, for example, a revolution, it seems likely to continue. If so, why spend time trying to time markets by buying and selling? There are many reasons why someone would trade and not invest:
Short-term trading is, at least for small individual traders, scalable. If you manage to find profitable strategies, you can build scale either via automation or increased size. Assuming you are a small trader, you can easily double your positions many times over. 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.
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. The price you are paying for long-term gains is to accept these drawdowns. No pain, no gain.
The aim of trading is 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 completely uncorrelated to the market without holding any positions overnight. Every morning I started with a clean sheet. The magic behind the uncorrelated returns was volatility and automation.
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 the year 2000 until 2010 is already long forgotten, and 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 come as both a surprise and disappointment for many.
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 equals action and exitement
Let’s admit it: trading is exciting and addictive. Long-term investing is mainly about holding your assets and waiting for appreciation, which is, of course, not very exciting.
Trading offers a faster way to wealth
Because trading is scalable and offers the opportunity to frequently turn around your capital, 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 are no guarantee of 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 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 need to adapt and learn faster than your competition. A high IQ is not necessarily an advantage. For example, the smarter 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.
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 of change.
Jeff Bezos once said that if you double your number of experiments, you double your inventiveness. What does this mean for a trader? You always need to 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 the 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 both passive and active funds.
Long-term investing is dependent on three factors: how much you save and invest, the return, and the time spent in the markets.
Even being below average makes sure you end up 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% return grows over time, but the overall returns are enormous:
Perhaps you have to pay for 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 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. You need 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 more 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 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.
If you’re a trader: use quantified strategies
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? When the 15-day RSI is below 30, what happens over the next ten days?
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 find out 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 learning. Moreover, talking to traders who have succeeded pays itself many times over.
You can both invest and trade
No matter what you do in life, 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.
If you want to become a trader, please make sure you know all the obstacles you have to overcome to be successful. Not only do you need to be good at trading, you 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 any specific skills to succeed, and you come a long way by eliminating the most obvious mistakes.
Disclosure: We are not financial advisors. Please do your own due diligence and investment research or consult a financial professional. All articles are our opinions – they are not suggestions to buy or sell any securities.