What's the difference between trading and long-term investing?

We often use the terms 'trading' and 'long-term investing' interchangeably, but they are, in fact, completely different approaches to investing in shares.

Understanding what separates trading from investing will help refine your investment strategy and could also prevent sticky tax issues.

Trading is buying shares with the intention of selling them again in a short period, hopefully making a quick profit. Traders focus on short-term price movements and may have little interest in the underlying businesses.

Like any good tradie, traders use various tools to gain 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 analysts' expectations or investor sentiment. Sentiment indicators can show how positive or negative other investors are feeling. Measures of sentiment include how much money is borrowed to invest on margin or how volatile share prices are.

Trading is a hands-on approach to putting your money to work because it involves continual buying and selling. This can incur significant brokerage fees, so traders must factor these into their investment decisions.

How does day trading work?

Day trading is an extreme version of trading, where people buy shares intending to sell them again the same day. 

The objective is to predict where share prices will move and buy the shares ahead of the change. Then sell them for a profit. Traders jump in and out of the market seeking to benefit from tiny price changes. These collectively add up to create more significant gains 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 about 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 Warren Buffett – one of the world's greatest investors and CEO of Berkshire Hathaway – thinks about successful investing. Buffett remarked in his 1996 annual letter to shareholders: "Our portfolio shows little change: We continue to make more money when snoring than when active."¹

The long-term investing process is very different from the trading process, and the tools are different, too. Rather than focusing on charts or short-term sentiment, long-term investors focus on company performance, industry trends, and macroeconomic factors. 

Long-term investors try to estimate the intrinsic value of shares by examining underlying financial and economic factors. This process is called fundamental analysis. 

Fundamental analysis involves examining a company's financial statements to evaluate its financial health, growth prospects, and competitive position. Macroeconomic factors such as interest rates, inflation, and economic trends that could impact the performance of the company and its industry are also taken into consideration. 

Investors conducting fundamental analysis may assess the competitive landscape, regulatory environment, and other industry-specific factors that could impact the company's performance. Having considered these factors, a long-term investor looks to buy when a share's market price is below its intrinsic value.  

The magic of compounding

Notice that the main focus here is on the business being invested in and how it will perform over the coming years. Once an investor has found a business 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."²

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 two decades later, in 2020, Berkshire Hathaway still held those shares and had even increased ownership in the two 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 that grow their earnings tend to become more valuable. 

Shares represent a small slice of company ownership, so the more a company earns per share, the more investors are willing to pay. This is especially true if they believe the business can continue to grow its earnings over time.

For investors, growing revenue is usually a sign of a healthy business as it allows the company to invest further in sales and marketing to create more growth in the future.

The longer your investment time horizon, the more your investment returns will rely on the fundamental performance of the company invested in, rather than ever-changing short-term market expectations.

Buy and hold through the ups and downs

Investing through periods of stormy share market weather can be terrifying, but it's a crucial part of long-term investing. 

Long-term investors often follow a 'buy and hold' strategy. This means exactly what it sounds like. You hold on to your investments even when big storms hit and may even top up your portfolio when the market is down (this is called 'buying the dip' and is an effective way to reduce your 'dollar-cost average'). 

Why? Because share markets are volatile and fall regularly. Historically, share markets endure a fall of 20% or more (called a 'bear market') every four to five years. When this happens, it can seem like a good idea to sell everything and make for the hills. But this is when you need to hold tight. 

Share markets can also become stagnant for long periods. You might feel like your investments are going nowhere. Selling and investing somewhere else is tempting. 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 the two?

Holding for the long term can be more challenging than it sounds. Taking action by buying and selling shares makes us feel like we are in control of our money. But that doesn't mean we're doing any good. In fact, the research tells us we would be better off leaving it well alone!

One study of 66,000 United States households³ with investment accounts showed that investors who traded in and out of the share market underperformed the average market return significantly. 

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%. The study's conclusion does not mince words: "Our central message is that trading is hazardous to your wealth."

Another study on the fate of day traders in Brazil found a mind-blowing 97% of individuals who persisted with day trading for more than 300 days lost money.⁴ Only 1.1% earned more than the Brazilian minimum wage.

A matter of timing

Okay, but what about timing the market? Surely you'll be better off if you just avoid the big falls? In theory, perhaps, but the problem is that timing the market is tough to get right. 

Data scientist Nick Maggiulli, the COO of Ritholtz Wealth Management LLC, notes that between 1915 and 2020, the Dow Jones Industrial Average Index (DJX: .DJI) delivered a positive return on roughly 52% of days.⁵ 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 ten best-performing days over 82 years.

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 is an important issue to consider as it impacts on total investment returns. If you sell shares for a profit in Australia, you must pay capital gains tax (CGT) at your marginal tax rate. If you hold the asset for at least 12 months, however, you are eligible for a CGT discount of 50%.⁶ This means paying tax on only half of the net capital gain.

Shares can still provide some tax benefits if you sell them at a loss. You can use the capital loss incurred to offset capital gains made in the same tax year or future tax 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'⁷ 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. 

Just ask Buffett – one of his most famous mottos is: "Our favourite holding period is forever."

Holding shares forever is a great aspiration but never a hard and fast rule. Our lives change, and so does the world. Our investment portfolios are there to support us as we move through different life stages.  

As you approach retirement, for example, you may need to sell 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. This means adopting the mindset of a part-owner in every business you invest in. Over time, you will reap the benefits as your companies grow.

That's not to say it's easy, especially when share markets take a tumble. But tempting as it may be to move in and out of the market, the 'lazy investor' typically outperforms over time.