Understanding the difference between trading and investing

Most of us use the terms trading and investing interchangeably. Ironically, many investors become investors by default; meaning they buy a stock and tend to hold on to it because the price moves against them. That is called holding on hope and is one of the cardinal sins of trading. Suffice to say that both trading and investing do require a high level of skill and understanding of the market. However, here are 6 areas that differentiate a trader from an investor..

Trader focuses on the short term; an investor on the long term..
A fundamental attribute that distinguishes a Warren Buffett from George Soros is their time perspective. Warren Buffett is the classical example of a long term investor who looks to identify quality stocks and wait for the results to manifest over a period of time. A George Soros, on the other hand, is typically looking at mispricing opportunities for quick entry and exit. A trader is normally not overly bothered about the long term prospects and fundamental strengths of the company and tends to exit the position once the target is achieved.

Traders focus on discipline; investors focus on patience..
This is another important attribute that distinguishes a trader from an investor. The basic requirement for being a good trader is discipline. You need discipline in terms of stop losses, profit booking targets, risk management etc. An investor identifies a good stock and prefers to wait. As Warren Buffett put it succinctly, “Our holding period is forever”. That may be a slight exaggeration but it still captures the gist of investing. To make money in the long term, the company has to show the requisite performance, show sustenance, adaptability and also be recognized in the market. The entire process takes a lot of time and hence patience is the key.

Trading is all about protecting your capital; Investing is about conviction..
What is the primary job of a trader? It is not about predicting which way the market will go. Remember, a trader comes into the market with finite capital. The story is the same whether you are a small trader or a George Soros. At the end of the day, your capital is finite and hence your risk has to be managed to protect your capital. The investor has to focus a lot more on conviction in his view. More often than not, this conviction has to be against all kinds of odds, which is why investing truly becomes a game of how sure you are about your view.

Trading is normally leveraged; Investment is not..
Let us provide a clarification here. There are many who borrow to invest in the long run. If an investor feels that the returns on a stock can far exceed the cost of debt then it makes sense to borrow money and invest in equities. Leverage in trading is a slightly different ball game altogether. Your position is based on a multiple of your affordability. Your capital protection is not determined by the size of your order but by the width of your stop loss. Whether you are trading equities, futures or options, the element of leverage in trading is a key component that distinguishes it from investing.

Trading plays both ways; investing is normally uni-directional..
What does an investor do if he is not convinced about the stock or if he finds the target has been achieved? The answer is to exit the stock. Even if the investor is holding on to a stock and the company shows deteriorating business environment, then the best option for the investor is to exit the stock and buy it later if justified. The trader has the luxury of playing the market on the short side. For example, the trader can short equities on an intraday basis. Traders can also borrow and short equities. They can do the same by selling futures on the stock, buying put options or even selling call options depending on their risk appetite. That way, a trader has a lot more flexibility to play markets on the short side. Remember, the greatest trade ever (John Paulson shorting sub-prime in 2007) was actually a short trade.

Traders normally ride the momentum; investors ride on value..
The success of a trader over a longer period of time lies in his ability to trade with momentum on his side. Of course, one can argue that big traders like John Paulson, George Soros and Tudor Jones have made big money by betting against the markets, but such opportunities are rare and very few. Normally a trader has to treat the trend as his friend. You cannot be a perpetual contrarian if you need to be a successful trader. Investors, on the other hand, focus more on value and can be largely indifferent to the flow of momentum and direction of the market.

Having outlined the differences, there are also some commonalities. Both a trader and an investor must have a passion for numbers and data. Both need to be very adaptable and willing to learn in a constantly changing market environment.  Above all, the investor and the trader must have the humility to accept that the market is smarter than individual traders and investors put together!