When it comes to being in the markets, do you know the difference between investing & trading?
Many people who do not deal with money markets daily. You may be missing the significance of just how different investing and trading are from one another.
While trading is essentially a type of investment, the term investment usually signifies something long term. For example, a home purchase is often referred to as a good investment. Or you may be thinking of investing in the stock market. These examples are often seen as long-term investments, but would you consider them a trade?
For the most part people generally see trading as a short-term move; a get-in, get-out opportunity. You put money into something and within a short period of time get a return on their money. Most people also might not realize that trading against an asset is also an investment. For example shorting a stock is just as important as buying a company’s stock for growth.
Know the difference between investing & trading to avoid missing opportunities.
We all know that we should be “invested” in one way or another. We are all familiar with the knowledge that we should be putting some of our earnings aside for retirement goals. When it comes to saving a percentage of our income every month and making an investment that we perceive as “good”, many people discover that it is just not that simple.
This is where it is important to know the difference between investing & trading. Not every investment should be meant for the long term and should instead be treated like a trade. I would say, all your investments should have a projected exit price. Determining that price should be a part of your risk management. This is also not exclusive to investments in bonds & equities or currencies but all net worth increasing assets.
Your investments, all of them, have a life span. From your home to your choice in a company stock, each one has a beginning, middle and end of life. Every company that exist since inception will lead to a peak in performance before descending towards an end. Consumer trends, competition and many other factors determine the length of that life span. In the end, nothing last forever.
Part of financial planning is knowing when you need to increase or reduce risks to your investments. When we make investments,we consider our personal goals and project out. Our goal is to determine if we can have a higher expectation for them to meet our objectives. Some investments will have a shorter life span and the goal and expected timeline needs to be determined.
How can you know when is the right time to invest or trade?
Knowing when the right time to invest can seem daunting. We see markets fluctuate dramatically and believe it or not, most people feel the exact same thing you do; fear. No one wants to invest into a market only to see some devastating news that tanks their investment. Not only is it hard to swallow financially but emotionally. But then how can you invest knowing these risks exist?
There are several things you must know and do to survive and keep your sanity.
The first thing you absolutely must understand is what’s known as your personal aversion to risk. This simply means to ask yourself, how much risk can I take on without completely freaking out. Each individual has a level of risk aversion. You must have some idea how high or low your tolerance for risk may be.
How do you determine your aversion to risk level when investing & trading?
Start by examining your current level of financial stability. Are your bills current & up to date? Are you struggling to pay bills or are they being paid on time without a worry? Do you have a proper savings and emergency fund set up? Is your source of income(s) protected in case of emergency?
Your level of financial stability will help you determining how much risks you are willing to accept.
The next thing you want to determine is what your goals are for yourself and your family. This is your time to discover what it is you are working for and why. Think about what you need in the near and long term. Also consider the needs and wants of your family and begin to write them down.
Is it a new home? Retirement? Start a business? Home project. Vacations? Kids college tuition? Write down the things you need and will be unable to live without. Don’t forget to allow yourself to dream about the things you would like to have or achieve in life.
Once these goals are figured out to some degree of certainty, you’re on the way to making them a reality. Now work to determine what assets you will invest in. Focus on those that may help you reach your goals. Consider the risks you’re willing to accept, as well as how you can protect those investments from known risks. This is where knowing the difference between investing & trading is important.
Have clear expectations & goals when investing & trading.
When we are investing, we are saying we have an expectation of a return greater than our investment. But how much greater? 5%? 100%? Also how long are we willing to wait for that return?
Let us say for instance one of our goals is to buy a new car. Obviously, this is not something we want to wait around 20 years to be able to achieve. So, we need to find the best investment vehicle. One that will potentially help us reach our goal in the shortest amount of time. The problem is, the shorter time, while usually providing the greatest returns, also come with the greater risks of loss.
How can you reach your investment & trading goals?
Once you know the difference between investing and trading, there are several things you must consider. First, how long do you want to work towards the goal? Second, how much risks are you willing to take to get there? As I mentioned above, the shorter the term the higher the risks. Your goal is to find an investment in the middle ground. If you are willing to take on more risks, then you may be looking for trade opportunities. If you are looking for less risk, you may be looking towards longer term, more secure investments.
This is one reason for diversification: for example, in a mutual fund or ETF. Our long-term investments goals like retirement may start off as risky when we are younger. The closer we are to retirement we want to reduce that risk substantially until there is truly little risk exposure.
When we trade for shorter term, we are willing to accept the potential for greater risk. In return is the potential of greater reward. This is where most people make mistakes. When you make this trade, you are willing to trade your cash for the potentially greater return. But must understand the possibility of greater losses. You are essentially trading your money for either greater gains or greater losses.
Therefore, you must be willing to accept the possibility of loss. Understand that in the long term, the potential of reward may exist based on your research. Your due diligence is to determine the likelihood of that outcome based on past performance of that particular asset. You may enter a trade and in the short term suffer loss. In the long term there is a greater probability of gain considering market averages. We also consider where the asset is in its life cycle. While past performance does not dictate future performance, it is indicative of potential future performance.
Consider this fact, on average the S & P market returns are around 7 – 10% annually since inception. Despite recessions and dramatic market pullbacks, the market has since its beginning not only recovered the losses but recovered. Those who held out recognized a profit.
No one can predict a bottom or top of an investment & trade.
While that should be your goal, there are too many variables behind an asset price change. It is impossible to know exactly when and where price changes will take place. What they do know, is that the probability of their investment going against them is possible. They also know the probability of it going in their favor is determined greater based on their due diligence.
The question becomes, how long and far am I willing to accept loss before I reach my risk aversion? How much am I willing to potentially lose in comparison to how much I expect to gain; risk/reward.
This period of loss is also known as draw-down or float. It is a significant factor for you to know the difference between investing and trading. Draw-down is measured from the time when you have entered a trade and the price goes against your entry price into negative until price returns to entry and goes positive. Since no one can accurately determine tops or bottoms, nearly all traders’ trades suffer periods of draw-down. The important thing is that the loss is unrealized so long as you still hold the trade. Yes, your trade is in the red, but you have not realized an actual monetary loss. Realized loss occurs when you close the trade.
I am not suggesting to hold trades indefinitely until you hopefully realize a profit. What I am saying is that with significant and proper due diligence, along with the probability of average market returns, you should feel greater confidence in your investment & trade choices. Not all trades & investments will work out.
If you have determined your level of aversion to risk, you should already know before making the trade just how much draw-down your willing to stand. You should know this before closing the trade and taking the actual loss in relation to your expected profit percent. Effectively, you are saying how much am I willing to lose. In comparison to how much I am expecting to gain.
This is also why you do not trade with money you are not willing to lose. The money you are not willing to take losses on is better suited for longer term and more secure investments.
When you know the difference between investing & trading, you can make better decisions. Knowing the level of risk your willing to accept will help you make better decisions. And knowing the difference between investing & trading will help you allocate money and how long you will keep it there. While all trades may be investments, not all investments are trades.
For further discussion to help you know the difference between investing & trading, check out this informative article: https://www.investopedia.com/ask/answers/12/difference-investing-trading.asp