Investing Verses Trading; Why investing is better

  • Trading returns by their inherent nature are volatile, because profit from trading is dependent on price volatility
  • Investing has a long-term, capital preservation focus, with an emphasis on risk management
  • On a risk-adjusted basis, investing delivers superior financial outcomes, compared to trading
  • The key to investing – you can’t predict the future; but you must prepare for it
  • Investing is a long game; that measures risk and return, is research-based, relies on diversification, is not driven by emotion, recognises that value is more about ‘quality’ than ‘cheap’, and focuses on the long term.

Financial advisors are sometimes asked if trading can achieve a superior financial outcome to investing.

The simple answer is, in the very short-term – possibly yes, although beyond the short-term – unlikely. The fact is that trading, by virtue of its nature, has a short-term focus and returns can be volatile. This is because profits from trading are dependent on price volatility, and volatility is a measure of risk. The higher the level of volatility, the higher the level of risk. The risk of high volatility or extreme price fluctuations is that a trader can be forced to sell at an extreme low point, because of insufficient liquidity to continue holding the investment. This can occur because of a margin call from an asset lender holding the traded asset as security for a loan, or simply the immediate need for cash that can arise for many other reasons. The outcome is a significant capital loss. The problem for an investor seeking to recover a significant capital loss lies in the mathematics, because a much higher return is required on the reduced capital value to recoup the lost capital amount. For example, an investment that declines by (say) 50 percent, requires a gain of 100 percent, just to return to its original value!

Investing, on the other hand, enables risk to be managed, and capital preserved. This is the primary objective of investing, compared to trading – capital preservation. To an investor, with a long-term focus, short-term price volatility is the price paid for long-term outperformance. This is the case across various asset classes, whether it be shares, property or other investment grade assets.

So, in the final analysis, on a risk-adjusted basis, investing delivers superior financial outcomes, compared to trading, especially beyond the short-term.

Why investing for the long-term works.

Investors who retain flexibility and an open mind in their investment strategy, based on a carefully considered plan for the short-term, intermediate-term and long-term, are best positioned for investment success. This means maintaining an investment plan suited to the times. Times, facts and markets change, and when they do, one’s investment strategy should also change, to reflect the times.

The world, and so it follows that investment markets, are currently going through change. After decades of low or no inflation, historically low and at times zero global interest rates, inflation and interest rates are now rising around the world. For rational investors, these changes are neither unexpected, nor expected. This is because investors know that you can’t predict the future; but you must prepare for it. Investors do this by retaining an open mind, contemplating all options from the immediate term out to the long term. After, all it wasn’t raining when Noah built the Ark.

Another reason why investing for the long-term works is that investing provides exposure to growth, and growth is the key to building wealth. The world has continued to grow since historical record-keeping began, so growth isn’t about luck – it’s how the world works. Discerning investors understand this key point and why it is fundamental to creating and sustaining wealth.

Long-term investing with exposure to growth assets outperforms sitting on cash, even by going to cash for a short period. Yes, there is invariably someone who claims that they outperformed the market by going to cash just at the right time. Going to all cash means you must make two correct investment decisions – when to get out……………. and when to get back in – and making enough money to cover lost income and taxes. There is always someone claiming to be able to time the market perfectly – most people can’t. Just because someone wins Gold Lotto each week, doesn’t mean that buying lotto tickets is a sound money-making strategy!

Investing, especially with the advice of an independent financial advisor, works also because rational, long-term investors are not swayed by emotion, dips in the market or headline commentary from journalists seeking to sell newspapers. Buying shares on market dips just because they’re down, not necessarily what’s cheap, is not smart investing. Discerning investors understand that value is not presented simply because a share price has fallen. Price information is free and the reason it is free is because it contains no information about value. Investment success seeks out long-term value, by combining independent research and analysis, patience and opportunism.

Furthermore, rational investors are less affected by human foibles than others because they lock out and ignore the natural human biases that often cloud sound and informed investment decision-making. Some of these behaviours are:

  • Anchoring, which refers to the tendency of investors to attach their views to irrelevant, out-dated or incomplete information in making decisions,
  • Confirmation bias, which is an investors’ inclination to selectively seek out information which supports their existing views and to ignore or dispute information that does not,
  • Loss aversion, which refers to an investors’ natural tendency to prefer avoiding losses to realising gains, and
  • As with life, investors are predisposed to a herd mentality in that people tend to make decisions based on the actions of a larger group.

So investing is all about playing the long game; one based on a strategy that measures both risk and return, is research based, relies on diversification, is not driven by emotion, recognises that value is more about ‘quality’ than being ‘cheap’, and focuses on the long term by ignoring short-term blips or ‘noise’, that can often distract investors from their over-arching objective.

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