Trading Versus Investing

It is important to understand the differences between trading and investing if you want to achieve your financial goals. Nearly everyone does some kind of investing, even if it's just placing money in a low interest checking or savings account. The idea is to set money or some other asset aside in the hope of getting a return on your investment in the future.

Trading is similar, except it usually involves a shorter time frame. It also involves a different mindset and strategies for success. It generally involves buying stocks, commodities or currencies and then trying to sell them a short time later for a profit. The time frame can be a few months or even a few minutes.

Trading isn't for everyone, while investing is something we all need to do. Most people would do well to avoid trading and concentrate instead on sound investing practices. However, there is a problem that makes it useful for investors to understand a little bit about trading, even if they don't plan on actually trading.

The problem relates to human nature. Many investors act like traders, while many traders act like investors.

Let me give you an example that recently happened to me. A friend of mine is a successful trader of silver (among other things). He also acquires and sells physical silver for longer term investors. Recently, silver rose in price very quickly and made us both some money on our silver trades. We were discussing the future prospects of silver and he told me he wouldn't mind if silver fell off a bit so he could provide some of his clients with silver at a more reasonable price. Well, in the next couple of weeks, silver depreciated substantially. We closed out our positions at a profit and began to wait for conditions to improve before entering the market again.

Later, I was discussing the silver market with my friend and asked if he was at least able to acquire some physical silver for his clients now that silver is much cheaper. No, he explained that his clients wanted to wait until silver was going up in price again before they bought any. He expected that he would get more orders when it was a few dollars more an ounce than it is now.

Why would someone want to wait until something got more expensive before buying it? Well, there are times when this is appropriate, especially for traders. Many traders use momentum to their advantage. They don't mind paying a higher price when prices are going up and there is a good chance they will be able to sell later at a profit. This might cause them to avoid buying a low priced commodity that would be attractive to some investors.

Good traders generally avoid buying something just because its cheap. They know that if prices are going down, they may continue to go down, often much further than most people would expect. They may be able to eventually sell at a profit, but this might take much longer than the time frame they have in mind. They don't want to spend a long time losing money on an asset when they could be using that money more profitably elsewhere.

Longer term investors, however, often make an investment because it is at a low price relative to fundamental considerations. Still, they can take a lesson from traders. It doesn't make much sense to spend a lot of money on an investment that might be much less expensive in the near future. Such an investor might decide to buy just a little bit now and then buy a little more in stages over time. This is known as dollar cost averaging and has the advantage of allowing you to buy more when prices are lower than when they are higher. This can lower the average cost. This is different from buying more of something just to get a better average price when prices are going down, especially if this exceeds prudent money management and your risk tolerance. This can be a very dangerous practice and can result in staggering losses very quickly.

Other investors may wait for prices to stop going down altogether and only jump in when prices are going up again. The won't get the cheapest price, but it can be safer than when prices are going down. It's still a good idea to protect against the possibility that you are just buying a short term upswing that will be followed by further declines. An investor can use a stop loss order to automatically exit the position if the market reverse. (He might place the stop loss a short distance below the recent lowest price or he might use another strategy like calculating the exit based on a decline of certain percentage of the investment's value.) Or he might decide that he can afford to just hold on because he can reasonably expect it to appreciate in value over time. If this is the case, he would be wise to decide in advance if his risk tolerance and money preservation practices will allow him to buy more if the price goes down even further.

One of the most dangerous times for an investor is when prices are high and going higher rapidly. People get excited at times like these and their enthusiasm can be very contagious. Crashes are sometimes the end result. Traders can make a lot of money at these times. However, it must be remembered that traders use different techniques. They will likely use fairly tight stop losses to protect themselves if the market reverses. They aren't investing for the long term, but are looking to exit on a shorter time frame so there is a good chance they can turn a profit, even if the long term potential is for a steep decline in prices.

I won't recommend specific strategies, but an investor would be wise to reflect on the dangers of these times and be careful not to let his emotions get the better of him. This doesn't mean that he shouldn't invest at all. He should just be aware of the dangers. For example he might buy reduced position sizes and make sure he has stop loss orders to preserve his capital. If the market keeps going up, he can then move his stop to a break even level or even lock in a small profit.

It is common and dangerous for investors to act like traders or traders to act like investors. This can easily happen when investors get blinded by the short term over optimism that often precedes crashes or when traders get distracted by a cheap price in relation to his perception of the fundamental value of an asset and overlooks what prices are doing now in the present.