The Basics of Investing and Trading

A position
In trader parlance, one takes a “long position” in an asset if he/she buys that asset and takes a “short position” if he/she borrows that asset and sells it.

The difference between investing and trading
Investors are people who buy assets (in this case, stocks) in anticipation of long term appreciation in their value. Traders are people who buy (or short sell) assets, expecting to profit from short term appreciation (or decline) in their value.

So can be observed, investing and trading are two totally different activities.

Long term and short term investing
Investors buy assets (in this case, stocks) for the long run, typically for periods in excess of 5 years. Medium term investors invest with time horizons of 1-3 years while short term investors invest with time horizons of les than 1 year. Traders and speculators hold positions for short periods lasting less than 1 year. Day traders hold positions for less than 1 day at a time.

Returns to be expected from investing
Before one starts investing/trading, it is important to have a rough idea of the kind of return to be expected. Returns from investing in broad-based developed market indices over long periods (30 years +) tend to be about 10-12 % p.a. Returns from emerging market indices tend to be higher than those from developed market indices. Investing in individual stocks is more risky than investing in diversified portfolios and often yields more than investing in broad based indices.

Returns to be expected from trading
Returns from trading stocks vary significantly and could theoretically range from negative infinity to positive infinity. Speculative investments in stocks have often yielded over 100% in a single day, just as they have also resulted in returns of minus 90% over a few hours. This kind of volatility is especially present in penny stocks and stocks of companies in emerging markets. Trading is risky business and therefore should be approached with caution by beginners.

Risk
Risk here, is defined as the volatility of returns. For the sake of quantification, risk is taken as the standard deviation of the returns earned from an investment.
Assume that Stock A’s monthly returns are 5%,-6%,10%,1%,-8% and that Stock B’s returns are 1%,0.2%,0%,-0.2%0.2% .Stock A is considered more risky than Stock B since its standard deviation of returns is 7.5% while that of Stock B is 0.45 %. That is despite the fact that Stock A has a higher average return than Stock B.

Risk and Reward
In the world of investing, the reward that an investor gets depends heavily on the risk that he/she is willing to take on. Government bonds are the least risky and could yield anywhere between 1% and 5% p.a. depending on the maturity of the bond, the issuing government, the currency of issue and the prevailing interest rates. Bonds of robust companies with fairly certain cashflows yield more than government bonds while bonds of companies with poor credit ratings yield even more. Stocks and real estate typically have the highest average return as well as the highest risk(volatility of returns) among all asset classes.

If one desires a high return, she must be willing to take on a higher amount of risk. It is improbable that one will consistently be able to find investments with low risk and high return.

Further Reading

I would recommend  the book,“A Random Walk Down Wall Street” to those interested in reading more about the basics of investing.