Shaun van den Berg, Head of Client Education at PSG Wealth
If you like to dabble in the markets, it pays to have a firm foundation and understanding of the difference between investing, trading, speculating and gambling. These terms are often confused, so here’s a helpful summary of the main differences.
Investing or trading
The main difference between investing and trading is the time horizon chosen. A trader prefers a short time horizon (anything less than three years), while an investor generally looks at anything over three years. Although both approaches attempt to profit from a financial transaction, they are very different.
The main objective when investing is to build wealth over the long term by buying and holding a diversified portfolio. Many share investors lean towards fundamental analysis by concentrating on financial ratios such as price-earnings (P/E) ratios, return on equity and interest cover to help them find undervalued, quality shares with manageable risk. Investors aim to grow their capital over time, supplemented by reinvesting profits and dividends. They will typically hold their shares through inevitable market fluctuations (with the expectation that the market will recover) and invest consistently year-in and year-out.
A trader, on the other hand, buys and sells shares more frequently to try and make (and take) quicker profits. They either buy low and sell higher, sell high to buy back at a lower price (when trading derivatives such as single stock futures) or buy high and sell higher (momentum trading). Traders also prefer to use technical analysis to find high-probability trading setups. When a trade goes against them, disciplined traders exit the trade quickly to minimise losses by using protective stop-loss strategies.
Trading is not the same as speculating
The main difference between trading and speculating is the amount of risk you take. Typically, high-risk trades that are similar to gambling are classified as speculation, whereas lower-risk trades based on technical analysis fall into the category of trading.
Trading can result in significant financial loss if you do not know what you are doing. Disciplined traders use stop-loss strategies and position-sizing techniques to manage the risk on each individual trade. They also hone their skills by reading technical analysis books or attending trading seminars. Ultimately, prudent traders look for situations that present high rewards but low risk.
When it comes to speculating, the risk of significant loss is offset by the possibility of a huge gain. Speculators are aggressive traders who take big risks – especially when anticipating future price movements – in the hope of making quick, large gains. As such, speculators must have expertise in the instruments they are trading. These usually include highly leveraged investments such as single stock futures and contracts for difference.
Speculating and gambling
While often confused with gambling, speculation involves a calculated risk and is not dependent on pure chance. Gambling, however, depends on random outcomes. Speculators make an educated decision on the direction of a trade, but the risk inherent in the trade tends to be significantly above average.
Achieve your wealth objectives prudently
Irrespective of whether you like to invest or speculate, you will undermine your wealth if you take unnecessary risks or make ill-informed decisions. It pays to have a prudent approach, or to get advice if you need guidance on how to make the best decisions to meet your financial objectives.