2.1 Savings, Investing, Trading, Speculating
What is the difference between saving, investing, trading, and speculating? Sometimes people think they are saving, when they are really investing. Or they trade when they are trying to invest. Sometimes people simply don’t know the difference between investing and trading so they just end up saving. And that’s a real shame.
Wealth building comes from knowing your money strategy and working it wisely. The main difference between saving, investing, trading, and speculating is the degree of risk you take with your money. But in this era of volatility and in times of inflation, sometimes the conservative position puts money at greater risk.
Let’s look at these choices.Savings begin when you put aside a part of your income and spend less than you earn. The foremost goal with savings is preservation of capital. Not losing money is more important than growing your money. Typically, savers place their money in some secure, low-risk place. If you ask yourself how to save money, these are considered low-risk options: a dependable bank, cash, physical gold, a savings bond, or a certificate of deposit.
People save because they have a use for the money in the future. They could save for education or to buy a costly item, an expansive vacation, or a house, to pay for a wedding, or even just for a rainy day. Sometimes they save in order to put aside enough money to invest. Most experts recommend having a savings of 6-8 months of your living expenses.14
- Advantage: Cash allows you to move quickly when needed. You can invest when the right opportunity comes along. If you have a medical emergency or lose your job, you have money to tide you over.
- Risk: You could lose cash. Banks may fail. You lose money as your savings typically do not keep up with inflation. You also lose the opportunity to earn income from investing
Investing puts your money to work for you in a deliberate, productive way. Most experts recommend at least a three-year investment timeframe. And the longer your money is invested the more it can work for you.
Most investments are into a business you think will perform well. When it comes to more specific examples of how to invest money, investors typically buy into reputable companies with established value. You may be a partner in a private company, or own shares in a public company. Investors want to see a return on their money. Returns come from growth in the value of the company or dividends.
- Advantage: You can grow your wealth much faster with higher returns. Steadily compounding dividends can grow your money exponentially.
- Risk: Markets fluctuate with politics, current events, news cycles, and business management. You can lose money on pullbacks. Not all companies prosper, some fail.
Trading is a kind of investing with a shorter timeline. Traders look at potential profits in fast moving markets. They may make many trades on an hourly, daily, or perhaps weekly basis.
Traders take advantage of the volatility and uncertainty of the financial markets. They seek to profit from fast rises and falls that happen from short term day to day activities. The markets are always moving. Up, down or sideways. They want to take advantage of every opportunity. Traders use a variety of charting tools and analyses to predict where the market is going and when the trend will change.
While this kind of trading is considered speculative, skilled traders manage their trades so the winning trades outnumber the losing trades. They accept losses as a part of the nature of their trading, but work to minimise the losing trades and maximise the winning ones.
- Advantage: While past performance is no guarantee of future results, well-researched trading based on fundamentals and not emotion has produced stable returns you are not likely to see from other kinds of investments. Check out eToro’s Popular Investors page where you’ll find plenty of skilled traders who you can chat with or whose trades you can copy.
- Risk: You must be able to accept losses in your account and have the self control to keep your emotions in check as you trade. All trading involves risk. Only risk capital you’re prepared to lose and past performance does not guarantee future results.
Speculating is high risk behavior. Here people hope for big gains but also take on considerable risk. The trade might be called ‘a long shot’. Typically, it’s very difficult to assess the outcome as to whether it will be in your favour or not. Speculators require a keen business sense, strict safeguards and a deep understanding of the market or they will soon be out of business. Investors may speculate with money they can afford to lose.
- Advantage: possibly fast rewards.
- Risk: Losing all capital plus MUCH more.
2.2 The Theory Behind Making and Losing Money
Growing wealth requires the understanding of how to make money. Some people think the only way to earn money is through a job or working for it. But investors know how to use money to make money. This is called passive income because you didn’t actively work for it.
Stocks: When you own your business, or are a partner in a business, you get a share of the business profits. Likewise, you share in any loss of the business. If you own a stock, you own a share of the company. You might own 1/1,000,000,000 of the company, but you are part owner. Some companies pay dividends. That means they share their profits with the stock owners.
Companies paying stock dividends often pay them quarterly. They may also pay dividends monthly, annually, or make special payments. People who want to use this dividend income may ladder these companies. That is, they choose stocks with different dividend payout dates so they receive income from dividends each month.
When companies grow, they increase in value. You may make money as your stock price goes up with the increased value. When the stock price does not rise with the actual value of a company, the stock may be called undervalued. If it’s priced higher than the company’s true value, it means people are willing to pay more than a stock is technically worth. Stocks may be overvalued if shareholders believe the company is likely to do great things in the future.
Many investors specialise in finding undervalued companies. They expect investors will eventually see the value and the stock price will rise quickly, giving them a better return. You realise the gains from a stock that has grown in value only when you sell the stock. Until then, it’s called a paper gain.
Bonds: A bond is a debt note or IOU to a government, corporation, or municipality. You agree to loan them money. In return, they issue a bond for a fixed amount, a fixed time, and a certain rate of interest. When you hold the bond to maturity, you are promised they will pay you the face amount of the bond plus interest due.
Investors make money through the interest paid on the bonds. If interest rates drop, the value of the bond may increase and they may make money selling the bond before maturity. If interest rates rise, the bond may lose value, although it should still pay interest and return the principal at maturity. If interest rates rise too high, you may actually lose money by holding the bond to maturity. It will pay you less than the cost of inflation.
Some companies are less secure and a have lower bond rating. These bonds usually pay more interest, but they also carry more risk that the issuer will default and you will not regain your investment. These high risk bonds may be called junk bonds.
Currency Trading: Pairs money from two different countries. When currency is traded between these countries monies, they are called major currency trades
- British pound (GBP)
- Canadian dollar (CAD)
- Euro (EUR)
- Japanese yen (JPY)
- US dollar (USD)
Other currencies may also be traded. Traders sell, or short, one currency to buy, or go long in, the other currency. In a long EUR/USD trade, the euro is sold to buy the USD.
Traders speculate that the currency they sell will go down in price or the currency they buy will go up in price. If that happens they make money. If the currency they sell increases in value or the currency they buy loses value, then they lose money.
Commodity Trading: This trading started as farmers or manufacturers wanted to lock in a price of a commodity that would be delivered in the future. These are called futures contracts. Commodities can be ‘soft or have a limited shelf life such as corn, wheat, rice, or cattle. Or they may be called ‘hard’ or more long-lasting such as oil, cotton, gold, silver, or lead.
Most traders do not want to actually own the commodity. Rather they want to profit from the changing prices. They buy a contract expecting the price to rise so they can sell at a profit. If they believe the climate, season, demand, or economic factors will cause the price to drop, they may sell a contract at the high price and hope to buy it back at the lower price.
Commodity trading uses leverage and is speculative and high risk. Traders lose money when the price goes against them.
Stock Market Index: An index is a list of related assets. They can be related by sector, size, market, or category of asset. They are benchmarks to indicate the value of the stocks that make up the index. It’s a way of determining how well that sector or market is doing. For example, the S&P 500 is made up of the top 500 stocks trading on the New York Stock Exchange or the NASDAQ. The FTSE 100 measures the value of the top 100 stocks trading on the London Stock Exchange.
These give a sense of how the overall market is doing.
Market Sector indices help investors see the trends in those sectors. The indices can be grouped by country and by industries such as healthcare, financials, commodities, agriculture, transport, etc. These indices form the backbone for mutual funds and exchange traded funds (ETFs).
The indices themselves can only be traded with CFDs that are derivatives of the index. Mutual funds and ETFs can be built by purchasing the assets in the index and holding them in one fund. Investors seek to profit by gaining value as the indices rise.
ETFs: ETF stands for Exchange Traded Funds (ETFs), and it represents a basket of stocks or assets that reflect the index they want to duplicate. They diversify your portfolio as they act like a single stock, but hold a wide range of assets. The goal of the ETF is to match the index exactly. They do not use active management. They simply own the same assets the index does. Typically they offer lower fees than a mutual fund of the same kind. They can be actively bought and sold, and you can buy and sell options on them. ETFs have been designed to gain (or lose) 3x the price change of the index as it rises. A reverse ETF is constructed to rise in value as the index falls.
ETFs can track a market (like the FTSE), bonds, commodities, sectors and industries, foreign markets, and currencies. Investors may profit from ETFs as they match the bull market in a sector or as they buy an inverse fund when the index drops.
Mutual Funds: These funds are actively managed. They also diversify your portfolio as they hold many stocks in one fund. While they may track indices like ETFs, their goal is to beat the returns of the indices. Managers of mutual funds buy and sell assets in order to gain better returns. These trades can incur costs and have tax consequences.
Mutual funds are not actively traded on stock exchanges. Instead, they are priced after market closing. It may take several days to redeem your mutual funds for cash. And there may be extra fees associated with buying or selling mutual funds in addition to the management fees.
Mutual funds may offer an easy set-and-forget kind of investing if you choose excellent management and low fees. If not, you run the risk of underperforming funds with fees that strip you of profits.
CFD Trading: CFD Stands for Contract for Difference (CFD). Rather than buying or selling the actual asset, money may be made trading a CFD based on the underlying asset. You do not own the currency, commodity, or stock. You simply have a contract where you agree on the current price of the asset and you have the opportunity to profit from selling it or buying it back at a later date.The asset never changes hands. But the profit or loss that comes from the movement of the asset goes to the CFD holder.
Investing gives you many ways to potentially make money. Select a markets or investment tool that is likely to meet your investment strategy. You can simply buy or sell the stock, asset, or lots of a commodity or currency. You might invest in a limited partnership or Real Estate Investment Trust REIT. You may also be able to trade options or Contract for Difference (CFD’s).
To reduce risk in any of these kinds of trades, traders use stop losses, or fixed points at which they will sell.
Losing Money: Investors hope every trade will be profitable… but they are not. Careful research and preset stop losses can increase the chances for wealth building. But most investors still fail to prosper as statistics suggest they should. The Dalbar study shows the S&P 100 index averaged annual growth of 9.85% over the past 20 years. The average equity fund investor only gained 5.9% averaged over the same time.15 Why?
Most experts point to our emotions. Money creates feelings of fear and greed. When the markets are high, novice investors jump in…greedy for profits and afraid they will miss out. When markets fall investors panic and sell. At the bottom, when equities are attractively priced, investors are afraid to get back in. They’ve been burned once.
People overreact to both good and bad news. You see security prices jump after earnings reports or news events. The London stock exchange index, the FTSE 250 dropped 14% after the Brexit vote, but bounced back within a month. Scared investors who dumped their equities took a huge loss. If they would have held on, they could have profited. It’s vital to base decisions on predetermined choices, not emotions.
Investors also tend to be overly confident in their abilities. They may exaggerate the ability of past data to predict future movements. They may trust their ‘gut feelings’. So, what can you do?
- Tap into more experienced advisors or traders to help you stay calm in a storm.
- Set up a trading plan with rules you will follow, and don’t deviate based on emotions or news that may not affect the underlying value of the security.
- Research company values. If the valuations remain good there is no advantage to selling, even in a downturn.
- Choose conservative, dividend paying equities with good valuations and plan to hold them for the long haul.
Simply knowing the pitfalls gives you an advantage. Examine your emotions. If you are fearful, you may be trading outside your risk level. Move to investments with less volatility that you are more comfortable with.
Because we tend to be emotionally driven, smart investors and traders research, understand trends, and use calculations to determine the best entry and exit points. Then they trade based on the facts they’ve gathered and not on their emotions.
Experienced day traders and swing traders know that not every trade will be profitable. Instead they work the law of averages. They plan trades so there is greater upside than downside. Even if they lose 20% or even 50% of their trades, if they make more money on the winner than they lose on the losers, they can still profit. These traders work hard to eliminate emotion from trades, win or lose.
2.3 Who Is Your Source?
Your investment methods, goals, and beliefs depend on who you listen to. One source says the stock market will fall, be defensive. At the same time, another says it’s a bull market, go all in. How do you decide who to listen to?
- How does their philosophy match yours and your risk tolerance?
- Follow the money. How do they get paid?
- Do they have a personal stake?
- What is their track record?
Let’s look at some advice choices to see how they fit these criteria.
News Outlet Commentators: Their driving motive is to get people to listen to them. The dramatic, sensational, or unusual commands attention. They give outsized attention to high-flying assets and are less likely to comment on boring, safe, quiet equities that may outperform over time.
Typically, they have no personal stake in the investments. If their pick rises or falls – if they are right or wrong – it doesn’t really hurt them. And you’ll probably only hear about their winners, not when they chose poorly. You may not find a full track record of their investment advice. Their choices may not fit your risk tolerance or cover areas you want to invest in.
Your Friend/The Guy at the Party: Investment tips can sound like a sure thing. Be careful. These people don’t make money from their advice, but what is their track record with past picks? You may want to take the tip as a starting point to do your own research. There you can learn the true potential and see how it fits with your portfolio strategy and risk.
Financial Newsletters: These have a wide range of investment philosophies, focus, and risk management styles. It’s easy to find one that fits your investment style. You can see their track records. It’s a straight transaction: you pay, they give advice. They will tell you to what degree they are investing alongside you.
However, their goal is to sell newsletters, so you may see them talk about looming risks and dangers or actions you need to take right away! They may do this to make you think you can’t invest without their ‘wise’ guidance. And their predictions of future events have only a modest degree of success. Finally, they have to crank out recommendations on a schedule. Great picks don’t always come like clockwork so they may need to tout inferior ones.
Robo Advisors: Robo advisors offer a new low cost way to invest. It replaces human financial advisors with algorithms and computer formulas. Investors can tailor their portfolio as they answer a questionnaire that asks about their risk level, among other things.This is an easy set-and-forget way to invest. However, not all robo advisors give the same returns. They can vary about 5% even on a conservative portfolio.16 While costs are low, investment companies may place these investors into their own funds to gain revenue.
Popular Investors: Social trading platforms let you follow and copy trades made by other investors. With eToro, you can find an investor with your risk tolerance. You’ll find it easy to spread your investments over a wide range of asset as you copy several different investors.
Each Popular Investor’s history is open for all to see, along with their annualised profits. And you can be confident they are fully invested in the picks you follow. They are taking the same risks you will if you follow them.You can even check out the performance simulator. It will show you how your assets would have performed had you started copying at different intervals.
eToro Popular Investors receive payments based on the amount of copiers or funds invested in copying them. Thus, your success contributes to their success. Of course, all trading involves risk. Only risk capital you’re prepared to lose. Past performance does not guarantee future results. Trading history presented is less than 5 years and may not suffice as basis for investment decision.
Analyst Consensus: Analysts throughout the world spend hours poring over stock charts and fundamentals. They inform their clients, usually banks, investors, and hedge fund managers, about ideal trends and trades. When you take the aggregate, the total recommendations from many analysts, you can get a feel for the security. You may find answers to these questions.
- Should you buy the stock?
- What is the value of the stock?
- Where do they see the stock moving in the future?
eToro has collected this information under the Stock Research tab in easy-to-read chart form. You can see the analyst consensus as to whether to buy, sell, or hold.
Another chart gives the estimates of stock price increase or decrease. It offers a target price. Because analysts differ, you’ll see high, low, and average estimates.
The movement in hedge fund money also shows where they think the stock will go. Sometimes hedge fund decisions actually move the stock price when large amounts of stock are involved. Hedge funds are sometimes called ‘smart money’ because they detect trends and valuations before the average investor. Still, their advice is not foolproof or guaranteed in any way.
eToro’s research page gives you insight into their buying and selling patterns. One chart shows a hedge fund buying and selling against the blue line of the stock price.
And finally, a simple meter tells you the sentiment of the funds toward the stock.
Truthful advisors will tell you there are no guarantees. Past performance does not guarantee future results. Only risk capital you are prepared to lose. They may talk about ‘high probability’ of a security doing well, but no one can make promises. You will need to do your research and make your best decisions, which will lead to your own ‘high probability’ of more successful trades.
This is a marketing communication and should not be taken as investment advice, personal recommendation, or an offer of, or solicitation to buy or sell, any financial instruments. This material has been prepared without having regard to any particular investment objectives or financial situation, and has not been prepared in accordance with the legal and regulatory requirements to promote independent research. Any references to past performance of a financial instrument, index or a packaged investment product are not, and should not be taken as, a reliable indicator of future results. eToro makes no representation and assumes no liability as to the accuracy or completeness of the content of this publication, which has been prepared utilizing publicly-available information.
eToro is a multi-asset platform which offers both investing in stocks and cryptoassets, as well as trading CFDs.
14 Pant, Paula ‘How much should you keep in savings?’, Bankrate.com, 18 Oct 2014 https://www.bankrate.com/financing/saving-money/how-much-should-you-keep-in-savings/#ixzz4YgM2BX6f.
15 Anspach, Dana. ‘Why Average Investors Earn Below Average Market Returns: Investor Overreactions Cause Poor Historical Returns’. the balance. 28 Aug 2016. https://www.thebalance.com/why-average-investors-earn-below-average-market-returns-2388519.
16Anderson, Tom. ‘Returns Vary Widely for Robo Advisors with Similar Risks’ CNBC, 7 September 2016. https://www.cnbc.com/2016/09/07/returns-vary-widely-for-robo-advisors-with-similar-risk.html.