Investing and trading – the differences
There are two main ways in which money can be made by participating in the stock market, investing and trading. The object is to make profits either by trading using short-term strategies or by playing the long game by investing (buying and holding shares) for the medium to long term to benefit from company growth and to take dividends. Unlike investors, traders attempt to maximise their returns on a daily, monthly or quarterly basis by taking advantage of falling and rising markets and the increase in the value of the shares of an individual company.
The object of investing money is to grow its value over time. That can be achieved by placing it on deposit to receive compound interest payments (not a very attractive proposition at the moment even with ISA tax relief) or by purchasing an asset that is likely to increase in value over time, such as a house. That is the most common form of investment for people in the UK, and it has proved very lucrative. If a property has been owned for many years, it will have benefitted enormously from the inflation in house prices seen since the UK came out of recession in 1992.
Many working people contribute to a personal pension scheme. Personal pension contributions benefit from tax relief and are another investment option to provide a degree of financial security that we will need to be able to enjoy our retirement. Workplace pension schemes have also been available since 2012 in which contributions are deducted from pay. If an employee is entitled to automatic enrolment, the employer is also required to contribute.
The stock market
Another investment option is to buy and hold shares in companies listed on the London stock exchange. It has proved to be an excellent long-term prospect, yes the market does fall in value at times, but it has a record of clawing its way back to pre-fall levels and beyond. FTSE 100 companies are those with the highest market capitalisation, and the FTSE 250 is comprised of the 101st to the 350th largest listed companies. Shares can be purchased directly or held via Unit and Investment Trusts.
Stocks and shares ISAs are also popular investment vehicles. They provide better returns than cash deposits and encompass a wide range of assets that include bonds, shares, commodities and commercial property. The benefits are:
- There is no tax payable on profits – no capital gains tax liability
- Interest earned on bonds is tax-free
- Dividend income from assets is free of tax in an ISA
All forms of stock market investment carry a degree of risk. That has been highlighted by the COVID-19 crisis that is likely to cause some businesses to fail and others to stop paying dividends for the time being. The safest form of stock market investment is to take the long view and to buy shares in established companies that have a proven track record of steady growth and regular dividend payments. The American investor, Warren Buffett, has shown that to be the case. He is the CEO and chairman of Berkshire Hathaway, perhaps the most successful investment firm in the world.
Traders buy and sell assets more frequently than investors. They buy and sell shares, commodities and a range of other financial instruments in an attempt to make faster returns than by buying and holding on to assets. They also trade on the forex market, attempting to make profits from the movement in the value of currency pairs.
The aim is to secure regular profits by buying low and selling high within as short a time as a month. A proficient trader will expect to make returns of 10 per cent in a month whereas an investor would be content to make that in a year.
Profits can also be made when a market is falling by selling at a high price and then buying back at a lower cost to ‘cover’. The technique is known as ‘short-selling’. It is speculative trading and is best left to experienced traders. If successful, profits can be high, however, so can losses if the gamble, because that is what it is, on possible price fluctuations proves to be unsuccessful.
When short selling a trader ‘opens a position’ by borrowing shares from a broker, hoping to make a profit on them before they are returned. While the position is open, the trader will pay interest on the value of the shares to the lender. To close the position, the trader buys back the shares from the market at a lower price than they cost to borrow. They are then returned to the lender.