Many people use the words "trading" and "investing" interchangeably when, in reality, they are two very different activities. While both traders and investors participate in the same marketplace, they perform two very different tasks using very different strategies. Both of these roles are necessary, however, for the market to function smoothly. This article will take a look at both parties and the strategies they use to make a profit in the marketplace. (See also: Passive Vs. Active Management.)
What Is an Investor?
An investor is the market participant the general public most often associates with the stock market. Investors are those who purchase shares of a company for the long term with the belief that the company has strong future prospects. Investors typically concern themselves with two things:
- Value: Investors must consider whether a company's shares represent a good value. For example, if two similar companies are trading at different earnings multiples, the lower one might be the better value because it suggests that the investor will need to pay less for $1 of earnings when investing in Company A relative to what would be needed to gain exposure to $1 of earnings in Company B.
- Success: Investors must measure the company's future success by looking at its financial strength and evaluating its future cash flows.
Both of these factors can be determined through the analysis of the company's financial statements along with a look at industry trends that may define future growth prospects. At a basic level, investors can measure the current value of a company relative to its future growth possibilities by looking at metrics such as the PEG ratio: that is, the company's P/E (value) to growth (success) ratio. (See also: PEG Ratio Nails Down Value Stocks.)
Who Are the Major Investors?
There are many different investors that are active in the marketplace. In fact, the vast majority of the money that is at work in the markets belongs to investors (not to be confused with the amount of dollars traded per day, which is a record held by the traders). Major investors include:
- Investment Banks: Investment banks are the organizations that assist companies in going public and raising money. This often involves holding at least a portion of the securities over the long term.
- Mutual Funds: Many individuals keep their money in mutual funds, which make long-term investments in companies that meet specific criteria. Mutual funds are required by law to act as investors, not traders.
- Institutional Investors: These are large organizations or persons that hold large stakes in companies. Institutional investors often include company insiders, competitors hedging themselves and special opportunity investors.
- Retail Investors: Retail investors are individuals that invest in the stock market for their personal accounts. At first, the influence of retail traders may seem small, but as time passes more people are taking control of their portfolios and, as a result, the influence of this group is increasing.
All of these parties are looking to hold positions for the long term in an effort to stick with the company while continuing to be successful. Warren Buffett's success is a testament to the viability of this strategy. (See also: Institutional Investors And Fundamentals: What's the Link?)
What Is a Trader?
Traders are market participants who purchase shares in a company with a focus on the market itself rather than the company's fundamentals. Markets that trade commodities lend themselves well to traders. After all, very few people purchase wheat because of its fundamental quality: they do so to take advantage of small price movements that occur as a result of supply and demand. Traders typically concern themselves with:
- Price Patterns: Traders will look at the price history in an attempt to predict future price movements, which is known as technical analysis.
- Supply and Demand: Traders keep close watch on their trades intraday to see where the money is moving and why.
- Market Emotion: Traders play on the fears of investors through techniques like fading, where they will bet against the crowd after a large move takes place.
- Client Services: Market makers (one of the largest types of traders) are actually hired by their clients to provide liquidity through rapid trading.
Ultimately, it is traders that provide the liquidity for investors and always take the other end of their trades. Whether it is through market making or fading, traders are a necessary part of the marketplace. (See also: What Can Traders Learn From Investors?)
Who Are the Major Traders?
When it comes to volume, traders have investors beat by a long shot. There are many different types of traders that can trade as often as every few seconds. Among the most popular types of traders are:
- Investment Banks: The shares that are not kept for long-term investment are sold. During the initial public offering process, investment banks are responsible for selling the company's stock in the open market through trading.
- Market Makers: These are groups responsible for providing liquidity in the marketplace. Profit is made through the bid-ask spread along with fees charged to the clients. Ultimately, this group provides liquidity for all the marketplaces.
- Arbitrage Funds: Arbitrage funds are the groups that quickly move in on market inefficiencies. For example, shortly after a merger is announced, stocks always quickly move to the new buyout price minus the risk premium. These trades are executed by arbitrage funds.
- Proprietary Traders/Firms: Proprietary traders are hired by firms to make money through short-term trading. They use proprietary trading systems and other techniques in an attempt to make more money by compounding the short-term gains than can be made by long-term investing.
The Bottom Line
Clearly, both traders and investors are necessary in order for a market to function properly. Without traders, investors would have no liquidity through which to buy and sell shares. Without investors, traders would have no basis from which to buy and sell. Combined, the two groups form the financial markets as we know them today.