Understanding the Basics of Investing vs. Trading: A Beginner’s Guide
Investing and trading are often discussed alongside one another, but they are distinct activities with different objectives and risks. If the terms like call, put, bids, asks, and spreads make you feel apprehensive, especially if you are not interested in intraday trading, this guide will help clarify these concepts to assist with your investment journey.
What is Investing?
Investing is a straightforward concept involving the purchase of assets with the intention of generating returns over a longer period. For many people, investing is the preferred route to building wealth steadily over time. A popular investment approach is to buy shares in an index fund, such as the SP 500 fund, which represents a diversified portfolio of stocks. Here, the strategy is to buy steadily and consistently, regardless of market conditions. This means that during market downturns, you buy more shares, and during market highs, you buy fewer shares. This method leverages the power of diversification and dollar-cost averaging, making the process less volatile and more manageable.
Basics of Investing
For new investors, one of the simplest strategies is to make regular investments in a broad market index fund. For example, if you receive a paycheck every two weeks, you can invest a fixed amount in an SP 500 index fund. Over time, you will accumulate a substantial number of shares, which can appreciate, especially if you remain invested through market cycles.
What is Trading?
Trading, on the other hand, refers to the buying and selling of financial assets with the intention of generating profit from short-term price movements. While the underlying assets (like stocks, options, or commodities) are the same, the focus and the methods used in trading are quite different from those of investing.
Common Trading Terms Explained
Call and Put Options
Call options and put options are financial derivatives that give the holder the right, but not the obligation, to buy or sell an underlying asset at a specified price (strike price) by a specified date (expiration date). These can be likened to prop bets in sports, where you bet on the outcome of a specific event. In options trading, you are essentially betting on the direction of the market's movement. If a trader buys a call option, they are betting the price of the underlying asset will rise before the expiration date, and if they buy a put option, they are betting the price will fall.
Bid, Ask, and Spread
In trading, bids and asks refer to the best available prices at which buyers and sellers are willing to trade. The bid price is what a buyer is willing to pay for an asset, while the ask price is what a seller is willing to accept. The difference between the bid and ask price is called the spread. Investors who are looking to hold assets over a longer period, such as investing in an index fund, do not need to be concerned about these fluctuations, as their investment horizon is not short-term.
The Risk vs. Reward Equation
A key principle in both investing and trading is that big returns usually equal big risks. Skilled traders with sophisticated trading strategies often generate substantial returns, but these traders often earn more from their ability to sell these strategies to others than from their own trading. For instance, someone claiming returns of 200% per month would, if true, exponentially increase a $10,000 portfolio to $83 billion in two years—a scenario that is mathematically impossible. Thus, the idea that speed and quick returns are the path to wealth rapidly depreciates over time.
Conclusion
Deciding whether to invest or trade largely depends on your financial goals, risk tolerance, and investment horizon. Investing is easier and more manageable, especially for long-term goals. Trading, on the other hand, requires more knowledge, skill, and time to be successful. If you are looking for a simpler and more straightforward approach to building wealth, investing in broad market index funds may be the best choice for you.