Last Updated on April 26, 2022 by Rational thinking
Which is more profitable – trading or investing? Who makes more money – traders or investors? The short answer is that you can get rich quickly by short-term trading, but you are more likely to make money by long-term investing.
A good trader can make a lot of money, but most traders lose money. Most long-term investors get a decent return after some decades, but you are unlikely to get filthy rich. However, the odds of a positive outcome are much higher for long-term investors. Most leveraged short-term traders fail, while most un-leveraged investors prosper. Thus, most are better off by investing than trading. Trading requires skillsets that differ substantially from investing.
Trading vs investing:
Trading is attractive because you can make a lot of money in a short period of time. Trading is scalable. Scalable means something that can be easily expanded, thus more profitable.
However, you must have in mind that you are more likely to hear more often about successful traders than unsuccessful traders. We ignore or forget the effect of survivorship bias: we focus on the winners, we rarely care about the losers. As scale increases, so does the survivorship bias.
Trading is a game of binary outcomes: you either become successful (and rich), or you end up losing. The winner takes it all effect is much more dominant in trading than in investing. Most traders lose, only a few make a lot of money.
Investing is different- there are much less binary outcomes. A dentist can serve as an example of an investor. A dentist makes 300 000 USD a year with little variation and randomness. The dentist works a fixed amount of hours and thus has a limit on how much money he can make. The profession is not scalable – but the outcome has a much higher possibility of being positive.
The ecology of the markets
Most traders fail and end up losing money. Even worse, this doesn’t factor in the lost opportunity costs for spending your capital in other ways, for example investing. Just a tiny minority of the traders end up making a decent amount of money. We guess this number is around 1%.
It makes perfect sense that just a tiny fraction of the trading community is successful. Why?
Because trading doesn’t create any wealth. It’s a zero-sum game in the short-term, even for stocks. Just like all poker players around a table can’t win, so can’t all traders make money. Someone has to be the prey for the predators. Make sure you both understand the trading game and yourself. What is the market? Who are the competitors? What is your trading edge? In order to succeed as a trader, you both need to work hard and be adaptive to the ever-changing market cycles.
Compare this to investing: you don’t need to work hard and you don’t need to be smart. You can just invest in active and passive mutual funds and do absolutely nothing. In the long-term, the stock market is not a zero-sum game. The stock market creates wealth that is distributed to all owners – the shareholders. This is something you don’t participate in when you are a short-term trader. Additionally, you have a second tailwind: the FED keeps printing money and stocks have served as a good inflation hedge over the last 100 years.
Being an investor you only have to make sure you are diversified and patient. This way you can build wealth with a high probability of success. Unfortunately, this is not very exciting and takes a lot of time.
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The magic of time and compounding:
The advantage of investing is that you can let your capital compound. For example, if you invest in a diversified mutual fund, you can just put the shares/units in the drawer and more or less forget about it. The chances that you have a decent nest egg after 15-30 years are pretty high. The time you spend compounding is much more important than the amount you invest and save.
If you consider trading, please have a look at the chart below:
The chart shows 10 000 invested annually for 30 years with a 9% return: after 30 years you have almost 1.4 million in assets. Not bad! Of course, this is a long time to “wait”, and additionally the return is not guaranteed. However, the graph illustrates why most people should invest, not trade:
Most leveraged short-term traders fail, while most un-leveraged investors prosper.
Trading is stressful:
- Most short-term traders end up losing money, not making money. If you invest in a mutual fund, you will most likely make money over a ten-year horizon (depending on valuations, of course).
- Short-term trading involves spending a lot of time trading and doing research. Trading is a job. Opposite, if you invest in mutual funds the capital works for you while you make money in a regular job.
- Trading involves stress, both mentally and financially. Investing in a mutual fund does not involve much stress (buy and “forget”). Women are better investors than men simply because they “forget” their mutual funds. Men have a stronger urge to outsmart the market by buying and selling, which usually fails.
- You risk wasting your best years. Most traders are between 20 and 35, the years where you can improve your professional career. It’s not easy getting a job after 10 years as a trader and certainly not with mediocre results. In order to keep trading as a job, you need to make more money than in a regular job to offset the risk.
- Most traders take a lot of risks and just a few bad trades can ruin your finances (leverage often leads to ruin). Traders underestimate the sequence risk of ruin.
The skill sets of a trader vs. investor:
As an investor, you basically only need to skill sets: patience and self-control. You need the patience to let your capital compound, and you need self-control to avoid the mistake of selling into a panic. Warren Buffett has been invested in all panics and recessions over the last 65 years, and he has still managed to generate an 18% annual return. You will most likely not manage an 18% return, but even 9% makes a good nest egg after 2-3 decades.
We tend to complicate even the most simple plans. Women are better investors than men. Why? Because they are not trying to be smart. A simple saving plan where you force yourself to invest at certain intervals is the best and most simple way to do it. You don’t need to do any extraordinary stuff to become a successful long-term investor. Just stay in the game and don’t sell into a panic.
Trading is much more complicated and more can go wrong, not least because of leverage. Failure of self-control leads to overtrading and mediocre results. Furthermore, we tend to think we are more clever than we are. Self-directed traders and investors perform worse than funds, according to research. In other words, by trying to be smart, you risk ending up being foolish. Markets are highly complex, and it’s extremely difficult to make a good timing of both buying and selling.
Is it better to invest or trade? It’s wise to spend some time thinking about the pros and cons of both types of investment styles. As an investor, you spend most of your time sitting on your ass and not doing much. As a trader, you have to get off your ass and treat it like a job. Furthermore, trading involves different skill sets and much more can go wrong. Few people have the skill sets and mentality to become a trader. Thus, most are better off by investing passively for the long-term via mutual funds.