Home > Investing vs. Trading and the Power of Compounding

Investing vs. Trading and the Power of Compounding

October 20, 2020 By Mircea Vasiu

Financial markets are such a diverse place that everyone can find something to fit its goals. Some people prefer short-term trading to  long-term one. Speculation is a thing these days, especially since electronic trading provides fair spreads to retail accounts as well.

Some other people prefer long-term trading, also known as investing. Regardless of the product traded, a long-term perspective requires something else from the trader. One of them, for instance, is liquidity.

The stock market was on everybody’s lips this year as it recovered the initial coronavirus dip in a remarkable manner. The risk-on move that followed triggered one of the most “hated” rallies in the history of the United States market.

Who Owns Most Stocks?

According to a study run by Goldman Sachs, the wealthiest one percent of investors own most of the stock, representing around 53% of household stock ownership. Moreover, during the last thirty years, the top 1%, when judged by wealth, bought a cumulative $1.5 trillion worth of equity. At the other end of the spectrum, the bottom 99% sold about $800 billion.

This is a pure example of how generational wealth is transferred from “weak” hands to “strong” hands. What made these people sell their stocks? Even more importantly, what made the 1% to keep buying?

The answer comes from liquidity constraints. Investors are better off by leaving the money at work. Passive rather than active management worked, especially for retail traders. Speaking of retail stock traders, active trading (i.e., going in and out of stocks at each market news or turn) leads to higher associated costs and missed opportunities.

Long-term investors, on the other hand, have a different perspective. To start with, the power of compounding growth in time. Reinvesting dividends is the name of the game.

Playing the long game, at least when it comes to the U.S. stock market, has always paid off so far. It does not mean that the same happened all over the world – some markets are stuck in ranges for decades. Who has the willingness and patience to wait for such a long time for an investment to pay off?

However investors have two objectives in mind. In sharp contrast with short-term oriented traders, one of the long-term investors’ objectives is capital preservation. Capital appreciation is welcomed but not mandatory – it fades in importance when compared to capital preservation.

To sum up, when thinking of investing in the stock market, step back for a bit and consider what type of investor you want to be. What prevails – capital preservation or capital appreciation?