What's the difference between trading and long-term investing?
These 2 terms are regularly used interchangeably but they are, in fact, completely different approaches to investing in shares. Understanding what separates trading from investing will not only help you maximise your returns on every dollar, but could also prevent some very sticky tax issues.
What is trading?
Trading is buying shares with a view to selling them again in a short period to make a quick profit. Traders focus on ever-changing up-and-down price movements and usually have little interest in what the underlying business is doing.
Like a good plumber, traders have a wide range of tools that they use to glean insights on what share prices might do next. Some traders use macro factors, like interest rate changes, job numbers or demand for commodities, such as oil.
Others focus on professional analysts’ expectations or investor sentiment. Sentiment indicators can provide a window into how positive or negative other investors are feeling. Measures of sentiment include how much money is being borrowed to invest on margin, or how volatile share prices are.
By nature, trading is a very hands-on approach to putting your money to work because it involves a lot of buying and selling. This means traders can end up paying large amounts in brokerage fees, which eat into their profits.
What is day trading?
Day trading is an extreme version of trading, where people buy shares with the intention of selling them again that very day. The objective is the same as trading: To try to predict where share prices will move next, buying shares ahead of the change, and then selling them for a profit. Traders quickly jump in and out of the market seeking to take advantage of tiny changes in price, which collectively add up to create larger profits over time.
Day traders use charts of historical price changes and the volume of shares traded to gain insights into where prices might move next. This is called technical analysis and is often enabled by special software packages.
What is long-term investing?
Compared to trading, long-term investing seems almost lazy. Your money is put to work and left to grow for years or decades.
In fact, ‘lazy’ is exactly how Berkshire Hathaway Inc (NYSE: BRK-A) (NYSE: BRK-B) CEO Warren Buffett – one of the world’s greatest investors – thinks about successful investing. In his 1996 annual letter to shareholders, Buffett remarked, “Our portfolio shows little change: We continue to make more money when snoring than when active”.
The process of long-term investing is very different to trading and the tools are different, too. Rather than focusing on charts or interest rates, long-term investors focus on the performance of the business itself. The aim is to understand how much money a company can make and estimate the company’s value. This process is called fundamental analysis. If a company’s share price is lower than an investor’s estimated value, the investor will look to buy the shares.
Notice that the main focus here is on the business and how it will perform over the years to come. Once an investor has found a business that they want to own a slice of, they can sit back and leave time (and the company) to do the hard work of compounding returns. As Buffett once told CNBC, “The money is made in investments by investing and by owning good companies for long periods of time”.
Buffett is a shining example of long-term investing. While he was “snoring’’ through 1996, Berkshire Hathaway owned 10.5% of American Express Company (NYSE: AXP) and 8.1% of Coca-Cola Co. (NYSE: KO). More than 2 decades later in 2020, Berkshire Hathaway still held these shares, and had even increased ownership in the 2 companies to 18.8% and 9.3% respectively.
Why does the long term matter? Because over time, company earnings can grow and compound at incredible rates, spinning off cash to patient investors. But it does take time. Companies need to invest in new factories, market their brands, and research new products that might take years to turn into cash for the company.
What moves share prices in the long term?
In the short term, share prices move for all sorts of reasons. Over long periods though, well-run companies tend to become more valuable as their earnings grow. Shares represent a small slice of a company, so the more money a company earns per share, the more investors are willing to pay for it. This is especially true if they believe the business can reinvest its earnings and continue to grow over time.
That might explain why over a 10-year period, almost 90% of the change in share prices has been linked to growth in revenue and profitability. For investors, growing revenue is usually the sign of a healthy business, as it provides capacity for the company to further invest in sales and marketing to create further growth in the future.
This means the longer your investment time horizon, the more aligned your success will be with the company’s fundamental performance, rather than ever-changing market expectations.
Buy and hold through the ups and downs
Investing through periods of stormy share market weather can be nauseating, but it’s a crucial part of long-term investing. This strategy is called ‘buy and hold’ and you need to make this commitment from day one of your investment. Even when big storms hit, your plan must be to hold your shares.
Why? Because you may initially buy your shares when times are good, but share markets can be volatile and they do fall regularly. Historically, share markets endure a fall of 20% or more (called a bear market) every 4 to 5 years. In times like this, that horrible feeling in the pit of your stomach can be a compelling reason to sell everything and make for the hills.
Share markets can also become stagnant for long periods. You’ll feel like your investments are going nowhere. Between December 2010 and December 2012, the S&P/ASX 200 Index (ASX: XJO) fell by 4%. In these times, selling and investing somewhere else often seems like an appealing idea. But don’t give up! The Motley Fool CEO, Tom Gardner puts it best: “If you invest for the long term, you don’t give up in the short term.”
How does your chance of success differ between trading and long-term investing?
Holding on for the long term can be harder than it sounds. We like to buy and sell shares because taking action makes us feel like we are in control of our money. But that doesn’t mean we’re any good at it. In fact, the research tells us we would be better off leaving it well alone!
One study of 66,000 United States (US) households with investment accounts at a large discount broker showed the investors who traded in and out of the share market significantly underperformed the average market return. The study revealed that the people who traded the most earned an annual return of 11.4%, compared to the market’s return of 17.9%. There was no mincing words in the conclusion of the study: “Our central message is that trading is hazardous to your wealth”.
Another study on the fate of day traders in Brazil showed an even more damaging figure. Conducted between 2013 and 2015, the study found a mind-blowing 97% of individuals who persisted with day trading for more than 300 days lost money. Only 1.1% earned more than the Brazilian minimum wage.
Okay, but what about timing the market? Surely if you just avoid the big falls, you’ll be better off? The problem is that timing the market is incredibly difficult to get right. Data scientist Nick Maggiulli, the COO for Ritholtz Wealth Management LLC, notes that since 1915, the Dow Jones Industrial Average Index (DJX: .DJI) has delivered a positive return on roughly 52% of days. So, it’s close to a coin-flip as to whether you will be successful if you’re trading in and out of the market.
Selling to avoid a loss also creates a new problem – deciding when to buy back in. Sitting on the sidelines can have a devastating impact on long-term investing gains. A report from US investment management company, Invesco showed returns decreased by about two-thirds if you missed just the 10 best performing days over an 82-year period.
Holding our nerve and hanging onto our shares, even when markets tumble, considerably improves our odds of building wealth. As the saying goes, it’s time in the market, not timing the market that counts.
Are there tax implications with trading?
Tax can be a sticky issue, especially when trading. Selling an asset for a profit in Australia incurs capital gains tax (CGT) that can significantly impact returns. If you sell the asset after 12 months of ownership, however, you are eligible for a CGT discount of 50%. This means paying tax on only half the net capital gain on that asset.
If you sell at a loss, that is a tax benefit, right? The short answer is ‘yes’. According to the Australian Tax Office (ATO), if you sell shares for less than you paid for them, the capital loss incurred can be used to offset capital gains over the year, or in future years. Selling shares at a loss specifically to reduce your tax liability is known as ‘tax loss harvesting’.
But be careful! Selling and repurchasing the same (or similar) assets within a short time, where there is no significant change in the investor’s economic ownership, is known as a ‘wash sale’ and can result in the tax benefit being cancelled.
What happens if you never sell your shares?
Generally, buy and hold investors hope they never have to sell their shares. Holding shares through thick and thin is considered the best path to not only preserving the long-term purchasing power of your money, but also truly maximising returns.
Just ask Warren Buffett, who has been investing since he was 11 years old. Yet, an astounding 97% of his net worth was generated after his 65th birthday! No wonder one of his most famous mottos is, "Our favorite holding period is forever”.
Holding shares forever is a great aspiration, but never a hard and fast rule. Our lives change quickly, and so does the world. As you approach retirement, for example, you may need to sell some shares to support your lifestyle, or buy your dream Harley Davidson to cruise down the coast. Other times, you may be forced to sell if one of your companies is taken private, bought out or starts to fade as new technologies change the way we live.
For us Fools, it’s the long term that matters
At the Motley Fool, we firmly believe that long-term investing is the way to go. Long-term investing means adopting the mindset of a part-owner in every business you are invested in and reaping the benefits as your businesses grow.
That’s not to say it’s easy, especially when share markets take a tumble. But as tempting as it may be to move in and out of the market, it is the ‘lazy investor’ who tends to outperform over time.
Figures correct as at 7 February 2022. American Express is an advertising partner of The Ascent, a Motley Fool company. Motley Fool contributor Regan Pearson contributed to this report and has no position in any of the stocks mentioned. The Motley Fool Australia's parent company Motley Fool Holdings Inc. has no position in any of the stocks mentioned. The Motley Fool Australia has recommended Berkshire Hathaway (B shares). The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.
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