So, i’ll start this article with a famous quote by the biggest compounder in the world,” Warren Buffet”. This will be the most important lesson when we discuss the question of Trading Vs. Investing. Irrespective of whether we do trading or investing, the objective is same, make money and not loose money. However, how we don’t lose money in both cases are very different. Also since I have sailed and also sailing in both the boats, I might be able to share the little experience which might be useful to the readers.
“The first rule of an investment is don’t lose (money). And the second rule of an investment is don’t forget the first rule. And that’s all the rules there are.”
Warrent Buffet
Trading vs. Investing: The Differences
So, back in the early days when I started learning about finance formally, the difference was not very clear. However as the years passed by and I read more and practiced more the difference was very clear.
Fundamental Differences
Now, a novice baby in this field would say, that the difference between trading and investing is the frequency of buying and selling. Also, to an extent that answer would be technically right. Trading does involve quick transactions, but can only speed motivate someone to pursue this technique? The answer is no!
Use of Leverage
- Firstly, Trading works on the principle of leverage. This means even if the price movement is 1%, you can make 10% if you use borrowed money.
So for eg; look at the example below. let’s say you had ten thousand rupees or dollars, and you use that as a margin in the trading platform to borrow 90% which would be ninety thousand rupees. While the stock or commodity that you traded on fluctuated by 1% on the upside. Hence, the bought asset increased from 100000 to 110000, which means a profit of ten thousand. However, you would calculate the returns on 10,000 and not 100,000 because your money is the former.
Risk Management
- Secondly, Trading is as much about increasing the returns using leverage, as it is about managing the risk.
So, let’s suppose 1000 is all you had and in case the price moved -5% with leverage, then you would be down 50% and if the price moved by -10% then you are busted. So, now its important to manage the downside. Furthermore, the basic strategy is to create 10 different price movement ideas and expect that 50% of the ideas won’t work. So you risk less as a % of the capital per trade, to reduce the risk.
Core Area of Interest
Now, the source of generating higher returns or not for both trading vs Investing. On one hand in trading, you want multiple types of assets like equity, gold, crude, zinc etc which can showcase different price movements at the same time. On the other hand, investing is about taking a long-term view of the business’s fundamentals and its ability to continue doing that in the future.
Trading Vs Investing: Financial Differences
Now, it is obvious that you would ask which is better. And at the same time, the answer is not just higher returns. Let me illustrate this point on the financial differences of Trading Vs Investing.
- Firstly, higher returns in trading comes with a huge tax liability at 30% business income tax. On the other hand investment in stocks have capital gain tax at 15% with indexation.
- Secondly, trading has operational risk which it carries. For example; since trading systems work on generating buy or short calls, if the underlying model itself has flaws then it can lead to total risk of ruin. On the other hand in case of investing, there can be the risk that the company turns out to be a total chop shop.
- Thirdly, the most important factor is that a trader is always thinking about the risk of ruin, whereas a fundamental investor is thinking about diversification.
So, which is better? Well, depends on your personality.
Trading is Better in Early Days: Trading Vs Investing which is better?
In my own experience, I found that in the first 10 years of my investment journey, I was more comfortable with higher risk with leverage. While in the later years, the huge tax liability and compliance cost, led me to shift to investing. Now, this is true for me, because I also transitioned into doing business myself, hence I was comfortable believing financial statements and holding my conviction. Hence Trading Vs Investing: Trading vs better.
So, if you had asked me the same question probably 10 years back even with the finance background? My answer would be no. Because building conviction on a stock in terms of its business doesn’t come so easily. I had to read multiple books to understand what makes a good business and what doesn’t. I will discuss some of my techniques in this article in the end.
Investing is Better in Later Years
As you grow old and manage larger capital, a 50% loss in both the cases of trading vs Investing can be very different. For example; lets say as a novice trader you are trading with a capital of 10 Lacs, hence a 50 % loss or drawdown would mean lets say loosing 5 lacs. and 150% loss in trading would mean loosing the principal of 10 lacs plus owing -5 Lacs to the broker. Which in my opinion is ok at the early years, because you can always earn it back.
However, fast forward this 10 years ahead and do the same calculation with 2 cr capital. Now, that would mean not just loosing 2 crs but also owing -1 Cr to the broker. Hence, loosing everything is not a problem but going negative is.
Trading Vs Investing: How do you learn?
So, I’ll just share my own experience with how I understood and applied both.
- Firstly, I started reading books on various trading styles; Peter Brant for technical analysis, Volatility Trading, Turtle Strategy by William eckhardt. Also, I ended being more comfortable with a system approach to trading using turtle strategy.
- Secondly, the major challenge I faced during the formative years was the difficulty in finding capital, which I beleive is one of the biggest challenge in trading. You can’t trade with 1 Lac, in terms of risk management and contract sizes, it becomes very difficult to trade effectively.
- Finally for investing, I have read a lot of business books because firstly I needed it for my own business itself. Secondly, the same books I read for my own business helped me in evaluating other business’s. Some examples of books I read include; Zero to one by peter thiel, Diamnonds in the dust by saurabh Mukherjea, Measure what Matters etc.
Also, finally the books itself, need to translate to reading complete annual reports of 5 years of every company in question, attending their con call meetings and doing primary research.
Final Thoughts
Whatever, you chose to pursue for wealth creation, bear in mind that you need to have the time and interest. Else, the best route for people in other professions who don’t have the time is to give this work to a professional fund manager. For eg; mutual funds have done an excellent job in creating wealth for their customers, provided that they stuck around with the discipline for atleast 10-15 years.