In today’s fast paced, media driven, advertising laden world we are bombarded with new ideas. Take this new drug and you’ll feel better (just don’t forget the side effects could kill you!). It’s hard to disseminate reality from what we are “told” to believe, feel, or think from the advertising mecca of today’s media.
I occasionally will receive a flyer in the mail inviting me to a conference to learn how to get rich by using new trading strategies. Learn how to become a trader, quit your job and become rich! Sounds good, right? Remember your mother told you not to believe everything you hear!
What’s the difference between trading and investing?
Trading and investing are two different strategies used to participate in the stock market, and they vary in philosophy, as well as, execution.
Investing is quite simple. By using the equity markets over a long time horizon, we can build wealth. Think of investing as the tortoise in the fable about the hare and the tortoise. With investing our objective is not to out run the hare (market). We simply want to capture what the market gives us…..we want market returns. Research has shown that over time market returns will out-perform other investment strategies, such as market timing (trading).
Simply put: investing using index (or passive) strategies can be a wise move for long term investors. What may seem old and stodgy is actually very wise and prudent.
Trading is a different approach to investing. Trading usually involves short (or shorter) term holdings to maximize the ups and downs of the market or individual positions. This means the trader must know when to get in the market (or holding) and when to get out. To be an effective trader one must get both sides of the trade correct from a timing perspective.
Some traders are only in an investment for a few minutes, while others can hold positions for several weeks or months…..but traders by definition will not hold an investment long term.
As a fee-only financial advisor (and a CFP®), I understand the equity markets very well, but I still am not confident enough to utilize trading strategies for my own portfolio (let alone clients’ portfolios!). Why? Because investing wins! Picking the right entrance and exit points, as well as, the appropriate investment is near to impossible when compared to the market.
Research compiled by Schwab Center for Financial Research illustrates this point in a compelling fashion. The data looks at mutual funds that try to out-perform the market (actively managed funds- also considered a trading philosophy). The research highlights actively managed funds that finished in the top quarter of funds in the same class (market segment). The data covers the ten year period from 2001-2010, and of the 1200 funds there are 1113 funds that finish in the top quarter for at least one year. So, almost all of the funds finished in the top quarter at least once in ten years.
The numbers change dramatically as the time frame lengthens. Funds finishing in the top quarter for at least five of the ten years drops to 130, and funds that finish in the top quarter for at least 8 or the 10 years is down to only 1. Are you talented (or lucky) enough to pick that one fund out of a list of 1200?
Sure, someone out there has hit a home run by picking correctly, but also remember someone picks a lucky lottery number every week, as well. It’s not about being lucky. It’s about being smart.
We can’t control the market, so why try? Simply capturing what the market will give us is all we need. It proves more productive to focus on controlling the things that are within our control. If we can control how much we spend, how much we save, and how much we pay in taxes, we will inevitably grow our wealth. Plug that in with a solid investment strategy based on a long term perspective (Investing) and you have a winning combination.
The next time you see a commercial showing a room full of traders staring at rows of high-tech computer screens advertising trading strategies you’ll know the truth. The commercial is advertising a strategy that is developed to make money, but more than likely, over time, you will not be the one making money. Remember, you can’t outperform the market over time!