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Stock Investing Vs. Stock Trading |
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Written by Value Seeker
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Tuesday, 18 December 2007 |
Most of the articles I write are about investing for the long haul. You buy a company because you believe they will outperform the market over a significant period of time, mainly because the company is undervalued or has growth prospects the market doesn’t fully appreciate.
When you invest in a stock, you aren’t committing yourself to holding the stock for years to come. If the company’s financials change or you decide for whatever reason you no longer view the company as a good investment, you sell the stock. But the idea behind making a stock investment is that you buy shares in the company with the intent of holding it for a year or more.
Another oft-cited way to make money is through trading stocks. When you trade a stock, you buy the stock with the intent on selling it rather soon. You may buy a stock and sell it later that day, or you may buy with the intent on selling within a month or two.
There are many reasons people decide to trade stocks. They may believe the company is going to have an exceptionally good quarter, so they buy a stock ahead of earnings. A stock might plummet due to bad news, and traders may believe that the stock will bounce back to a more fair value rather quickly. Others use charts to determine the short-term demand for the stock, and use the information gleaned from the chart to make trades. Chartists often do not know and sometimes do not even care about the fundamentals of the company or even what sort of company it is.
Both stock investing and stock trading can make you money, and people who are good at both methods can beat the market over the long-term. I’m not going to comment which method is easier to utilize to beat the market, since I personally don’t know. Some people might be good at stock investing, while others may be good at stock trading. Of course, some people will be bad at stock investing and others will be bad at stock trading. Both methods have their pros and cons. What is important is to understand the major advantages and disadvantages of each method that most people overlook:
Assessing Your Own Abilities
A major advantage of stock trading over stock investing is that you can determine how good you are at stock trading much faster than you can at stock investing. If you are stock investor, you really need to look at your 5-10 year results compared to the market before crowning yourself a good or bad investor. Any fool can get lucky and beat the market in a year, and even stock market pros can have the occasional bad year. To know for sure how good of an investor you are, you need a lengthy time span of about 5-10 years, which is quite a time commitment.
In contrast, stock trading has much smaller yearly variance. Because a trader will make hundreds, perhaps thousands of stock trades in a year, he will get a better idea how effective he is at beating the market using his trading system. Of course, certain variables can affect these results. If the trader tends to buy and then sell stocks of a certain sector, then the performance of that sector will greatly affect his yearly results. His system may inadvertently result in his buying of defensive or aggressive stocks, which will also affect his yearly performance. Nevertheless, compared to a stock investor, it is far easier and quicker for a trader to assess his level of competence.
Assessing your ability to beat the market requires keeping good records, which most investors and traders do not do. But if you are serious about either stock trading or stock investing, it’s a must.
Trading Fees
A major downside of stock trading is that only a few people can afford the fees resulting from frequent trading. Suppose you make about 20 trades a week, 50 weeks a year. That’s a total of 1000 trades. This will likely cost you around $10k a year (assuming $10 a trade).
Ten thousand dollars a year in trading fees isn’t a big deal if you have an asset base of $1 million or more. That’s just 1% of your asset base, which is what most mutual funds would charge. If you can trade better than most mutual funds can invest your money, you’ll come out ahead. However, if you only have $100k, this represents 10% of your asset base. Now, to beat the performance of an index fund, you need to beat the market by 10% or more just to match the market. You are handicapped so much by the amount of fees that you are paying that it is virtually impossible for you to beat the market.
It is no wonder that brokers’ advertisements appeal to traders, since traders rack up huge fees for the brokers. People with a million or more can afford the costs associating with trading, but John Q with $40,000 in his retirement fund cannot. Or, at the very least, would be greatly limited in the amount of trading he can do.
If you decide to trade, plan to keep your annual trading fees under 2% of your assets. Any more than 2% and you are looking at climbing too big of a hurdle to be able to beat the market. Your time is better spent either finding good long-term investments or just relaxing and doing something else while you park your money in an index fund.
Taxes
Another major advantage of stock investing is capital gains treatment on earnings. If you hold a stock for a year or more, your gains are taxed at long-term capital gains rate (15%) instead of your standard income tax rate (which can be as high as 35%). Tax considerations shouldn’t be your main factor in determining how to invest, but anything that causes you to pay less money in taxes or fees is more money in your pocket.
Diversification
Diversification can be both an advantage or disadvantage of stock investing. When you trade, you often do not know or care about what sector a company is in. Because of this, you may inadvertently put all of your eggs in one sector for a short period of time. Of course, since you are trading, this lack of diversification is temporary, so the ill effects of lack of diversification won’t hurt you too much.
When you invest, it is often difficult to beat the market and adequately diversify. Generally, people only understand a few stocks or a few sectors well. To be able to beat the market via investing, you generally need to know or understand something the market doesn’t, which is difficult to do so in many sectors. Diversification can easily be achieved via investing. In fact, it’s easier to do so through investing than trading since when you invest, you at least generally know what the company does. However, it’s difficult to maintain a diverse portfolio as well as expect to have an advantage over the market in all of these sectors.
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