Friday, June 12, 2009

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Is Investing in Stocks Better than Trading Stocks?

Investing and trading are not really two sides of a coin as many people think. They are not opposite things. The only difference in my view is the risk a trader takes for a given trade that determines whether they are investing or trading in stocks. Many people easily fall into the belief that investing is better than trading. Let me shatter this myth in this article and show why the contrary is actually true.

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Investing is a One Time Shot

Investing appears to an outsider to be similar to gambling. But to the investor it is not really so. Though it shares a lot of similarities with gambling and many so-called investors practically gamble with the markets, there is an aspect that makes these people slightly different from gamblers.

Investing is like a one time bet or one time shot. You will make it or break all in your only one attempt. For this reason investors study the markets and stocks and their background companies, economy in general before making their bets. Though this is time consuming task and also full of domain knowledge, this is what makes the investor’s bets better than gambling. Any trade done without a plan or reason is just gambling and returns from that can be attributed to plain luck.

Investing and Trading Both Help Each Other and the Economy

Investing money does not necessarily go into stocks. It can go directly into the business of the companies if not stocks. Even the stock market investments start for a company by investing directly for the growth of the company though initial public offers. Hence investing is more closer to contributing to the economic or industrial activity. It has a direct impact on the companies.

Trading is indirect. It is not a waste thing as many people think, who like to be called as investors. Without traders there cannot be a market as we see everyday. Traders make the bloodline for the market and keep it flowing everyday for the functioning of the markets.

If traders are not there then it will be a hard time for investors. The long term investors from large institutions need enough volume on any day to make a position into stock. Traders help build the momentum or volume for the day so that these investors can buy the stock easily without putting orders lower and lower with every transaction. It is basically the liquidity that traders contribute everyday to the markets.

Liquidity is important for not just stock markets but any business. Even if the economy is not good, enough liquidity can temporarily create rallies and sustain a short term bull market as we see today. Liquidity implies that it will be easy to get in and out of stocks with ease and without moving the price of the stock very much. Highly liquid stocks can be bought in thousands or even millions on single day. This is all due to the presence of traders who generally concentrate popular companies’ stocks.

That is how investors and traders work to create a stock market as we see today. No matter how old or new the technology is there were always traders and investors in the history of stock exchanges. Both contribute not just to create a market but in fact to help the turn-arounds or major growth phases of listed companies in the country.

I saw many people who think that stock market is like a casino and traders and investors are like gamblers without really contributing anything to the society. That is not true. In fact it is a part of our modern culture. It plays a great role in helping the economy and works like a virtual money lender which has more flexibility than banks or finance corporations.

Most of the people who start trading stocks, slowly start their bias towards investors. They think that investing is better than trading because they do not realize that trading is also like any other discipline. It is not just trading even investing does require same kind of study and effort on the part of the market participant as does their other businesses.

Investing is Not Low Risk Option But Trading is!

People tend to move towards investing because they think of the timeframes involved without bothering about how risk changes in the overall equation. There is a general feeling that investing involves low risk where it is exact opposite. Also people flock to investing because it gives them lot of free time to concentrate on their daily business. This is because they do their job only to certain extent as much as their current knowledge tells and get convinced there itself.

In fact investing is far more riskier than trading. It is because you do not have stop loss protections. I saw many traders who call their trades as investments when the trade turns into a loss. Instead of taking the loss they change their mind and plans, to let the stock do whatever it wants. They give more time for it thinking it will recover in a “long period of time”. Hence they name it as long term investment.

It is amazing how people shift their thoughts so easily when it comes to trading stocks. They also shift their identities as a trader to investor without much trouble. But the fact is that all big losses first start with initial small loss. A trader cuts them short and books them. An investor lets it become bigger and bigger until finally selling the stock when it just starts a turn around. How many times can you remember doing this in your own experience? I think many times unless you are learning your lessons.

Such is the risk involved with investing. You may now point out that same will hold true when it comes to making profits. By holding the investment long enough the investor stands to gain bigger. Let me tell that the reality is quite different. The stock can behave like that but not the investor. There are several reasons for this.

First of all many investors book profits soon because they can’t have an idea when to close the trade. That too they do it more often during uptrends much like they let the losses increase during downtrends. If an investor is sitting tight to hold the stock during uptrend it is much like the quality of a trader who does the same thing but with more certainty. Because the trader lets the market gives its signal while the investor looks for things that indirectly affect the market. These indirect things many times go out of phase and make the investor lose sight of the best price to get out of the position.

Investing is Not Necessarily Long Term

But there is another little catch here. Apart from the uncertainty of exiting that investors face, they also face the problem in time dimension. People think that investing is good because it is about long term. In fact the long time means either long term gambling or long term trading.

The stocks in reality make their biggest moves in only a short period of time. You can check all of stock markets histories. You will find that stocks spend a lot of time moving here and there. But only a part of the time they spend moving straight in one direction. It is only long term traders that get to catch this portion and make the best killing if not the maximum possible made by those bought at the bottom. Generally those who buy at the bottom fail to call the top at the right time.

The Reality of Long or Short Term When a Stock Moves…

The stocks move in a short period of time with all intermediate trends concentrated in that same time frame. Investors think that by capturing a stock for all its life time will increase the chances of grabbing its golden period of rising. That is actually gambling in the time dimension. Because you may be studying the stock and its company but leaving the timing for luck. Even the most successful investor Warren Buffet made the right timing for his entries and exits. All the principles will go into the ash if timing is not taken care.

Trading is Superset of Investing!

Don’t judge investing and trading based on false beliefs shaped by your trades that went bad. Learn lessons from them. Just take a step ahead and look at the reality. Trading offers more flexibilities than investing. Trading does not only have to be about day trading. It is like a superset of investing when it comes to the time and effort involved!!

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