Trading and investing might sound like interchangeable words for trying to grow your money in the stock market. But they mean different things—and come with their own set of risks and potential benefits. Knowing them can help you determine which one is best for your money and overall financial strategy.
What is investing?
Investing is buying an asset, like an individual stock, mutual fund, or exchange-traded fund (ETF), in hopes of increasing your money over time. Because most people invest for long-term goals, like buying a house, paying for college, or saving for retirement, they tend to hold these assets for a long time—meaning years, if not decades.
What is trading?
Trading is buying and selling financial assets, like individual stocks, ETFs (a basket of many stocks and other assets), bonds, commodities, and more, in hopes of making a short-term profit. Traders could be buying and selling investments multiple times a day, week, or month. Though technically you "make a trade" anytime you buy or sell an investment, most people associate trading with an active investing strategy.
Similarities of investing and trading
At their most basic level, trading and investing are identical. Both involve opening an account to buy and sell investments. And each offers the chance for you to pick a wide range of investment types to help you reach your personal goals. Here are other ways investing and trading are alike.
Opportunity for compound returns
Compounding is when you earn returns on your investments—then those returns start earning returns. When you put money in the stock market, you create the potential for an investment's value to compound. As time goes on, the power of compounding increases.
But compounding doesn't always work in your favor, especially with shorter timelines. When stock prices go down, your losses are compounding. To make up for lost ground, you must recover a greater percentage than what you lost. For example: If a $100 investment falls 10% to $90, it takes more than an 10% gain to bring it back to the original $100.
While the pluses and minuses of compounding impact both investors and traders, trading may come with greater risks when it comes to compounding because of the shorter timeline to recoup losses. Investing for the long term gives your money the chance to recover and grow again following a downturn.
Potential to earn dividend income
Certain investments, like some individual stocks and funds, provide periodic payouts called dividends. (Not all companies or funds do this; some prefer to invest their profits in themselves to grow and expand.) Dividend payments typically get paid quarterly and add up to 0.5% to 3% of the share value over the year.1
For some investments, that can be a substantial portion of their total return, or the percentage their price increases plus the amount they provide from dividends. From 1930 to 2021, dividend income made up 40% of the total return of the S&P 500® index,2 a group of the 500 largest US companies.
Pro tip: If you reinvest your dividends—a.k.a. when you automatically use your dividends to buy more shares of the investment that pays them—you could earn even higher returns. Since 1960, 84% of the S&P 500's returns have been from dividends (and their compound returns).3 Translation: Reinvesting dividends can help long-term investors bank higher returns. But remember, past performance is no guarantee of future results.
Goal of beating inflation
Inflation is like a hidden tax on your cash that occurs when prices go up and your purchasing power goes down. During "normal" times, inflation tends to run about 2.3% each year.4 But from June 2021 to June 2022, it's skyrocketed closer to 10% (9.1% to be exact), drastically shrinking the strength of each of your dollars.5 When you trade and invest, the goal is to earn positive returns. If they're high enough, they can offset and even beat out inflation, helping you build wealth.
Because trading encompasses a wide range of techniques and investment options, it can be hard to draw sweeping conclusions about its returns and ability to preserve your purchasing power. But it's important to note that the majority of short-term traders do lose money, making it even harder to fend off inflation.6,7
It's easier to calculate how long-term investors in diversified, broad-market funds fare against rising prices. Consider this: For the last 100 years, the S&P 500 has seen average annual returns of just over 10% each year, with dividends reinvested.8 That's enough to beat inflation and build wealth in a "normal" year when inflation is hovering around 2%. Even during times of high inflation, this average annual return helps you maintain your purchasing power.
Remember these are long-term results, and you shouldn't invest money you may need to cover immediate expenses in an effort to beat inflation. The stock market experiences many peaks and valleys over months and years. If you invest money you need to cover near-term costs, you may have to sell at a greater loss than inflation alone would have cost you.
Differences between trading and investing
Timeline isn't the only difference between trading and investing. Here are a few more.
Risk of loss Any investment carries a risk that you'll lose money. But buying and selling investments becomes riskier the shorter your timeline is and the more you concentrate your money into just a handful of holdings, 2 challenges traders often face. The stock market has historically recovered from every downturn it's experienced—but it hasn't always done so quickly or predictably. Recoveries can take years, meaning traders who purchase shares of stocks whose values fall may not have the time to wait out a rebound.
And while the broader stock market has recovered, not all company stocks have. Buying individual stocks, like many traders do, raises the risk that you could lose the money you invest. Diversified funds, meanwhile, spread your money across hundreds of companies. This helps smooth out any dips individual companies may experience by supplementing their performance with other companies' stronger returns.
In addition, to turn quicker profits, traders may purchase more complicated asset types, such as options, futures contracts, and swaps, as well as the use of margin—a type of loan that brokerages offer traders who agree to ante up assets they own outright as collateral. Although these techniques hypothetically may provide traders with higher potential profits, they also carry greater risks that may result in loss—and, in the case of margin trading, possibly even more.
Tax implications Almost anytime you earn a profit, Uncle Sam wants his cut. The same is true with investing and trading, though investing may help you pay less in taxes. That's because any profits you see on individual stocks, ETFs, and mutual funds are taxed based on the amount of time you hold them. For investments you own for less than a year, like those you trade over short periods, you'll likely pay taxes on the earnings at the same rate you would on your paycheck. For those you own at least a year and a day, like what you might invest, you become eligible for a slightly lower tax rate called the long-term capital gains rate.
If you experience losses instead of profits, whether over the short or long term, you can use these to offset gains you make on other investments or write them off on your taxes using a technique called tax-loss harvesting.
Note: Investments you hold in tax-advantaged accounts, like 401(k)s, individual retirement accounts (IRAs), and health savings accounts (HSAs), are not subject to the same tax rules. Losses cannot be harvested.
Time and effort Because of the amount of research and transactions it takes, successful trading can be—and often is—a full-time job. Long-term investing, meanwhile, most often takes a set-it-and-forget-it mentality. By buying a diversified fund or mix of investments, investors may be able to benefit from the historic long-term returns of the stock market with little effort.
This means they likely will experience all of the ups and downs that the overall market experiences—and unlike traders, they won't respond in real time to market events hoping to edge out market returns. This hands-off approach can pay off.
Portfolio representation Due to the amount of risk involved, trading typically only represents a percentage of someone's total investments—not their entire portfolio. This allows them to take on riskier bets without jeopardizing their long-term financial futures.