3. INVESTING VS. TRADING

3.1. Investing vs. Trading: What’s the Difference?

3.1.1. Investing vs. Trading: An Overview

Investing and trading are two very different methods of attempting to profit in the financial markets. Both investors and traders seek profits through market participation. In general, investors seek larger returns over an extended period through buying and holding. Traders, by contrast, take advantage of both rising and falling markets to enter and exit positions over a shorter timeframe, taking smaller, more frequent profits.

3.1.2. Investing

The goal of investing is to gradually build wealth over an extended period of time through the buying and holding of a portfolio of stocks, baskets of stocks, mutual funds, bonds, and other investment instruments.

Important

Investors often enhance their profits through compounding or reinvesting any profits and dividends into additional shares of stock.

Investments often are held for a period of years, or even decades, taking advantage of perks like interest, dividends, and stock splits along the way. While markets inevitably fluctuate, investors will “ride out” the downtrends with the expectation that prices will rebound and any losses eventually will be recovered. Investors typically are more concerned with market fundamentals, such as price/earnings ratios and management forecasts.

Anyone who has a 401(k) or an IRA is investing, even if they are not tracking the performance of their holdings on a daily basis. Since the goal is to grow a retirement account over the course of decades, the day-to-day fluctuations of different mutual funds are less important than consistent growth over an extended period.

3.1.3. Trading

Trading involves more frequent transactions, such as the buying and selling of stocks, commodities, currency pairs, or other instruments. The goal is to generate returns that outperform buy-and-hold investing. While investors may be content with annual returns of 10 percent to 15 percent, traders might seek a 10 percent return each month. Trading profits are generated by buying at a lower price and selling at a higher price within a relatively short period of time. The reverse also is true: trading profits can be made by selling at a higher price and buying to cover at a lower price (known as “selling short”) to profit in falling markets.

While buy-and-hold investors wait out less profitable positions, traders seek to make profits within a specified period of time and often use a protective stop-loss order to automatically close out losing positions at a predetermined price level. Traders often employ technical analysis tools, such as moving averages and stochastic oscillators, to find high-probability trading setups.

A trader’s style refers to the timeframe or holding period in which stocks, commodities, or other trading instruments are bought and sold. Traders generally fall into one of four categories:

  • Position Trader: Positions are held from months to years.
  • Swing Trader: Positions are held from days to weeks.
  • Day Trader: Positions are held throughout the day only with no overnight positions.
  • Scalp Trader: Positions are held for seconds to minutes with no overnight positions.

Traders often choose their trading style based on factors including account size, amount of time that can be dedicated to trading, level of trading experience, personality, and risk tolerance.

KEY TAKEAWAYS

  • Investing takes a long-term approach and often applies to such things as retirement accounts.
  • Trading involves short-term strategies to maximize returns daily, monthly, or quarterly.
  • Investors are more likely to ride out short-term losses, while traders will attempt to make transactions that can help them profit quickly from fluctuating markets.

ADVISOR INSIGHT

While one could consider their trading activities as investing, for me, the difference between trading and investing has more to do with time.

When you invest in something, you are looking to grow your money. Some people invest for a long time, such as for retirement, while others invest for a short time to hit a specific goal, such as buying a car. A person who owns an annuity, for instance, is investing for a longer time horizon than someone who enjoys trading stocks and moves their money around quite frequently.

Trading, on the other hand, suggests the investor is taking a very short-term approach and is principally concerned with either making quick cash or the thrill of participating in the markets.

3.2. Stock vs. ETF: Which Should You Buy

Say you’ve decided that you want to invest in a particular sector. Now you need to decide whether to buy stocks or an exchange-traded fund (ETF). Investors encounter this question every day. Many are under the impression that if you buy an ETF, you are stuck with receiving the average return in the sector. This is not necessarily true, depending on the characteristics of the sector.

3.2.1. Choosing Between Stocks and ETFs

Making this choice is no different from any other investment decision. As always, you want to look for ways to reduce your risk. Of course, you want to generate a return that beats the market (creating alpha.) Reducing the volatility of an investment is the general method of mitigating risk. Most rational investors give up some upside potential to prevent a potentially catastrophic loss. An investment that offers diversification across an industry group should reduce the portfolio’s volatility. This is one way that diversification through ETFs works in your favor.

Alpha is the ability of an investment to outperform its benchmark. Any time you can fashion a more stable alpha, you will be able to experience a higher return on your investment. There is a general belief that you must own stocks, rather than an ETF, to beat the market. This notion is not always correct. Being in the right sector can lead to achieving alpha, as well.

3.2.2. When Stock Picking Might Work

Industries or situations where there is a wide dispersion of returns or instances in which ratios and other forms of fundamental analysis could be used to spot mispricing, offer stock-pickers an opportunity to exceed expected returns.

Maybe you have a good insight into how well a company is performing, based on your research and experience. This insight gives you an advantage that you can use to lower your risk and achieve a better return. Good research can create value-added investment opportunities, rewarding the stock investor.

The retail industry is one group in which stock picking might offer better opportunities than buying an ETF that covers the sector. Companies in the sector tend to have a wide dispersion of returns based on the particular products they carry, creating an opportunity for the insightful stock picker to do well.

For example, let’s say that you recently noticed that your daughter and her friends prefer a particular retailer. Upon further research, you find the company has upgraded its stores and hired new product management people. This led to the recent rollout of new products that have caught the eye of your daughter’s age group. So far, the market has not noticed. This type of perspective (and your research) might give you an edge in picking the stock over buying a retail ETF.

Company insight through a legal or sociological perspective may provide investment opportunities that are not immediately captured in market prices. When such an environment is determined for a particular sector, where there is much return dispersion, single-stock investments can provide a higher return than a diversified approach.

3.2.3. When an ETF Might Be the Best Choice

Sectors that have a narrow dispersion of returns from the mean do not offer stock pickers an advantage when trying to generate market-beating returns. The performance of all companies in these sectors tends to be similar.

For these sectors, the overall performance is fairly similar to the performance of any one stock. The utilities and consumer staples industries fall into this category. In this case, investors need to decide how much of their portfolio to allocate to the sector overall, rather than pick specific stocks. Since the dispersion of returns from utilities and consumer staples tends to be narrow; picking a stock does not offer a sufficiently higher return for the risk that is inherent in owning individual securities. Since ETFs pass through the dividends that are paid by the stocks in the sector, investors receive that benefit as well.

Often, the stocks in a particular sector are subject to disperse returns, yet investors are unable to select those securities which are likely to continue outperforming. Therefore, they cannot find a way to lower risk and enhance their potential returns by picking one or more stocks in the sector.

If the drivers of the performance of the company are more difficult to understand, you might consider the ETF. These companies may possess complicated technology or processes that cause them to underperform or do well.

Perhaps performance depends on the successful development and sale of a new unproven technology. The dispersion of returns is wide, and the odds of finding a winner can be quite low. The biotechnology industry is a good example, as many of these companies depend on the successful development and sale of a new drug. If the development of the new drug does not meet expectations in the series of trials, or the FDA does not approve the drug application, the company faces a bleak future. On the other hand, if the FDA approves the drug, investors in the company can be highly rewarded.

Certain commodities and specialty technology groups such as semiconductors fit the category where ETFs may be the preferred alternative. For example, if you believe that now is a good time to invest in the mining sector, you may want to gain specific industry exposure.

However, you are concerned that some stocks might encounter political problems harming their production. In this case, it is wise to buy into the sector rather than a specific stock, since it reduces your risk. You can still benefit from growth in the overall sector, especially if it outperforms the overall market.

The Bottom Line

When deciding whether to pick stocks or select an ETF, look at the risk and the potential return that can be achieved. Stock-picking offers an advantage over ETFs when there is a wide dispersion of returns from the mean. And you can gain an advantage using your knowledge of the industry or the stock.

ETFs offer advantages over stocks in two situations. First, when the return from stocks in the sector has a narrow dispersion around the mean, an ETF might be the best choice. Second, if you are unable to gain an advantage through knowledge of the company, an ETF is your best choice.

Whether picking stocks or an ETF, you need to stay up to date on the sector or the stock in order to understand the underlying investment fundamentals. You do not want to see all of your good work go to waste as time passes. While it’s important to do your research so you can be able to choose a stock or ETF, It’s also important to research and select the broker that best suits you.

3.3. Why would a person choose a mutual fund over an individual stock?

There are a number of reasons why an individual may choose to buy mutual funds instead of individual stocks. The most common advantages are that mutual funds offer diversification, convenience, and lower costs.

Many experts agree that almost all of the advantages of stock portfolio diversification (the benefits derived from buying a number of different stocks of companies operating in dissimilar sectors) are fully realized when a portfolio holds around holds 20 stocks from companies operating in different industries. At that point, a large portion of the risk associated with investing has been diversified away. The remaining risk is deemed to be systematic risk, or market-wide risk. Since most brokerage firms charge the same commission for one share or 5,000 shares, it can be difficult for an investor just starting out to buy into 20 different stocks.

The convenience of mutual funds is surely one of the main reasons investors choose them to provide the equity portion of their portfolio, rather than buying individual shares themselves. Determining a portfolio’s asset allocation, researching individual stocks to find companies well positioned for growth as well as keeping an eye on the markets is all very time consuming. People devote entire careers to the stock market, and many still end up losing on their investments. Though investing in a mutual fund is certainly no guarantee that your investments will increase in value over time, it’s a way to avoid some of the complicated decision-making involved in investing in stocks.

Many mutual funds like a sector fund offer investors the chance to buy into a specific industry, or buy stocks with a specific growth strategy such as aggressive growth fund, or value investing in a value fund. If you want to track the overall market, you can buy an index fund. You can diversify into non-equity asset classes by buying a bond fund, which invests only in fixed income.

Some investors find that buying a few shares of a mutual fund that meets their basic investment criteria easier than finding out what the companies the fund invests in actually do, and if they are good quality investments. They’d prefer to leave the research and decision-making up to someone else.

Finally, the trading costs of frequent stock trades can add up quickly for individual investors. Gains made from the stock’s price appreciation can be canceled out by the costs of completing a single sale of an investor’s shares of a given company. Investors who make a lot of trades should take a look at our list of brokers who charge lower-than-average fees.

With a mutual fund, the cost of trading is spread over all investors in the fund, thereby lowering the cost per individual. Many full-service brokerage firms make their money off of these trading costs, and the brokers working for them are encouraged to trade their clients’ shares on a regular basis. Though the advice given by a broker may help clients make wise investment decisions, many investors find that the financial benefit of having a broker just doesn’t justify the costs.

It’s important to remember there are disadvantages of mutual fund investment as well, so as with any decision, educating yourself and learning about the bulk of available options is the best way to proceed.

Most online brokers have mutual fund screeners on their sites to help you find the mutual funds that fit your portfolio. You can also search out funds that can be purchased without generating a transaction fee, or funds that charge low management fees. The search function can also let you locate socially responsible funds.

An alternative to mutual funds are exchange-traded funds (ETFs). We have compiled a list of brokers that best serve investors who want to trade this particular type of asset.

ADVISOR INSIGHT

A mutual fund will provide diversification through the exposure to a multitude of stocks. The reason that is recommended over owning a single stock is that owning an individual stock would carry more risk than a mutual fund.

This type of risk is known as unsystematic risk. Unsystematic risk is risk that can be diversified against. For example, by owning just one stock, you would be carrying company risk that may not apply to other companies in the same sector of the market. What if their CEO and executive team leaves unexpectedly? What if a natural disaster hits a manufacturing center slowing down production? What if earnings are down because of a defect in a product or a lawsuit? These are just a few examples of the types of things that could happen to one company, but are not likely to happen to all companies at once.

Yes, there is also systematic risk, which is risk that you cannot diversify against. This would be similar to market risk or volatility risk. It should be understood that there is risk associated with investing in the market. If the market as a whole declines in value, that is not something that can easily be diversified against.

Therefore, if you’d like to invest in individual stocks, I would recommend researching how you can compile your own basket of stocks so that you don’t own just one stock. Make sure you are sufficiently diversified between large and small companies, value and growth companies, domestic and international companies, and also between stocks and bonds, according to your risk tolerance. This is where it might be helpful to seek out professional help when constructing these types of portfolios. This type of research and portfolio construction and monitoring can take quite some time.

The alternative is to invest in a mutual fund for instant diversification… of course, there are a list of things to be aware of when choosing mutual funds as well. Fees, investment philosophy, loads, and performance are just a few components to consider when evaluating mutual funds.

3.4. ETF vs. Mutual Fund: What’s the Difference?

3.4.1. ETF vs. Mutual Fund: An Overview

Investors face a bewildering array of choices: stocks or bonds, domestic or international, different sectors and industries, value or growth. Deciding whether to buy a mutual fund or exchange-traded fund (ETF) may seem like a trivial consideration next to all the others, but there are key differences between the two types of funds that can affect how much money you make and how you make it.

Both mutual funds and ETFs hold portfolios of stocks and/or bonds and occasionally something more exotic, such as precious metals or commodities. They must adhere to the same regulations covering what they can own, how much can be concentrated in one or a few holdings, how much money they can borrow in relation to the portfolio size, and more. Beyond those elements, the paths diverge. Some of the differences may seem obscure, but they can make one type of fund or the other a better fit for your needs.

3.4.2. ETF

As the name suggests, ETFs trade on exchanges, just as common stocks do, and the other side of the trade is some other investor like you, not the fund manager. You can buy and sell at any point during a trading session at whatever the price is at the moment based on market conditions, not just at the end of the day, and there’s no minimum holding period. This is especially relevant in the case of ETFs tracking international assets, where the price of the asset hasn’t yet updated to reflect new information, but the U.S. market’s valuation of it has. As a result, ETFs can reflect the new market reality faster than mutual funds can.

Another key difference is that most ETFs are index-tracking, meaning that they try to match the returns and price movements of an index, such as the S&P 500, by assembling a portfolio that matches the index constituents as closely as possible.

Passive management isn’t the only reason that ETFs are typically cheaper. Index-tracking ETFs have lower expenses than index-tracking mutual funds, and the handful of actively managed ETFs out there are cheaper than actively managed mutual funds.

Clearly, something else is going on. It relates to the mechanics of running the two kinds of funds and the relationships between funds and their shareholders.

In an ETF, because buyers and sellers are doing business with one another, the managers have far less to do. The ETF providers, however, want the price of the ETF (set by trades within the day) to align as closely as possible to the net asset value of the index. To do this, they adjust the supply of shares by creating new shares or redeeming old shares. Price too high? ETF providers will create more supply to bring it back down. All of this can be executed with a computer program, untouched by human hands.

The ETF structure results in more tax efficiency, too. Investors in ETFs and mutual funds are taxed each year based on the gains and losses incurred within the portfolios, but ETFs engage in less internal trading, and less trading creates fewer taxable events (the creation and redemption mechanism of an ETF reduces the need for selling). So unless you invest through a 401(k) or other tax-favored vehicles, your mutual funds will distribute taxable gains to you, even if you simply held the shares. Meanwhile, with an all-ETF portfolio, the tax will generally be an issue only if and when you sell the shares.

ETFs are still relatively new while mutual funds have been around for ages, so investors who aren’t just starting out are likely to hold mutual funds with built-in taxable gains. Selling those funds may trigger capital gains taxes, so it’s important to include this tax cost in the decision to move to an ETF.

The decision boils down to comparing the long-term benefit of switching to a better investment and paying more upfront tax, versus staying put in a portfolio of less optimal investments with higher expenses (that might also be a drain on your time, which is worth something).

Important

Keep in mind that, unless you gift or bequeath your ETF portfolio, you will one day pay tax on these built-in gains. So you are often just deferring taxes, not avoiding them.

3.4.3. Mutual Fund

When you put money into a mutual fund, the transaction is with the company that manages it—the Vanguards, T. Rowe Prices, and BlackRocks of the world—either directly or through a brokerage firm. The purchase of a mutual fund is executed at the net asset value of the fund based on its price when the market closes that day or the next if you place your order after the close of the markets.

When you sell your shares, the same process occurs, but in reverse. However, don’t be in too great of a hurry. Some mutual funds assess a penalty, sometimes at 1 percent of the shares’ value for selling early (typically sooner than 90 days after you bought in).

Mutual funds can track indexes, but most are actively managed. In that case, the people who run them pick a variety of holdings to try to beat the index that they judge their performance against.

That can get pricey. Actively managed funds must spend money on analysts, economic and industry research, company visits, and so on. That typically makes mutual funds more expensive to run—and for investors to own—than ETFs. Mutual funds and ETFs are both open-ended. That means that the number of outstanding shares can be adjusted up or down in response to supply and demand.

When more money comes into and then goes out of a mutual fund on a given day, the managers have to alleviate the imbalance by putting the extra money to work in the markets. If there’s a net outflow, they have to sell some holdings if there’s insufficient spare cash in the portfolio.

The Bottom Line

Given the distinctions between the two kinds of funds, which one is better for you? It depends. Each can fill certain needs. Mutual funds often make sense for investing in obscure niches, including stocks of smaller foreign companies and complex yet potentially rewarding areas like market-neutral or long/short equity funds that feature esoteric risk/reward profiles.

But in most situations and for most investors who want to keep things simple, ETFs, with their combination of low costs, ease of access, and emphasis on index tracking, may hold the edge. Their ability to provide exposure to various market segments in a straightforward way makes them useful tools if your priority is to accumulate long-term wealth with a balanced, broadly diversified portfolio.

KEY TAKEAWAYS

  • Both mutual funds and ETFs hold portfolios of stocks and/or bonds and occasionally something more exotic, such as precious metals or commodities.
  • A key difference is that most ETFs are index-tracking.
  • Mutual funds can track indexes but most are actively managed.