Often, when I write about stock market news, or other economic events, I conclude by reminding long-term investors that there is no need to overreact (or really react at all) to the current short-term events.
It was brought to my attention that not everyone is a long-term investor. That’s not true, but what is true is that not everyone is solely a long-term investor. And, that being the case, perhaps it is worth me addressing other investing types and issues, here on Finance Gourmet. That sounds fair, but in order to do so, I think I need to start with the different types of investors.
Different Types of Investors
The most common type of investor is the long-term investor. Everyone with a 401k or an IRA falls into this category. The goal of this investor should be to construct a well diversified portfolio and then review and rebalance it regularly. The strength of this type of investor is that over time, this is a sound approach that has never failed. The weakness of this type of investor is forgetting the strength and reacting inappropriately to short-term events.
This category could be broken into two sub-types, those who are only investing for retirement and college funding, and those who have enough resources to invest for other things, also with a longer-term horizon.
All other types of investors can be considered speculative investors. These are investors who take on greater risk, in the pursuit of greater reward. In doing so, these kinds of investors give up the “sure thing” of the long-term investor. Whereas the long-term investor will only lose money if he or she makes mistakes, the speculator can do everything right, and still lose money if things don’t work out. This is the key difference between the two types of investors.
There are several types of speculators
- Day Traders – The most mythical of all investors, day traders seek to exploit small, fleeting, price inefficiencies. Day traders are the urban legends of investing everyone has a cousin, or friend of fried, who became a millionaire while day trading. Contrary to popular belief, day traders don’t need to know anything about the companies and their underlying business. Rather, day traders try to predict where pricing will go in the next minute, or hour(s) based almost exclusively on pricing charts, and market mechanics like volume. Effective day trading cannot be achieved using mass market, online, trading platforms. You need a subscription to a real-time trading system like TradeStation to be a real day trader. The strength of this type of trading is that it not dependent upon news or other information. The weakness is that you never really know what the price movement will be. In some ways, it’s like playing poker, there is a skill and over time, that can/should work out in your favor, but you are going to lose plenty of times along the way as well.
- Technicians / Chartists – Another kind of speculator uses company stock charts to predict the movement of stocks. There are so many patterns that supposedly predict a stock’s future, that it takes thousand-page books to explain them all. The key to this type of trading is not news, or company data, but rather what the chart looks like. The strength of this type of trading is that it does not require in-depth company knowledge and profits (and losses) can be made quickly. The weakness of this trading is that it makes no accounting for outside events or data. A company trading “near support” will crater right through that support in reaction to news about that company, that company’s sector, or the market in general.
- Options Traders – Trading options is a high-risk business because leverage can make your profits and losses come fast and large. On the other hand, there are many ways to be able to mitigate or limit those losses (usually by reducing your potential upside). Option trading works much like regular trading. The strength of this type of trading is its potential for big gains and multiple strategies (there are way to profit whether the stock moves up, down, or not at all). The downside is that the learning curve is steep and it can take a large investing account to make all the strategies work properly.
- Fundamentals Traders – This is the trading everyone thinks is what Wall Street and big money traders do. This is also the kind of analysis that is most common from the various Wall Street analysts or newsletters. The idea is to analyze the data and see something before everyone else sees it. For example, noticing that IBM is generating more sales and buying the stock before others notice it. This is where price targets, and buy, sell, hold recommendations come from. The weakness in this kind of investing is that being right doesn’t matter. You only make money when the market agrees with you, and the market can (rightly or wrongly) disagree with you for a very long time. When the Internet Bubble was wildly expanding, numerous analysts noted (correctly) that stocks were grossly overpriced based upon their fundamentals and potential. But being right lost money all the way until the bubble finally popped. By then, anyone who had shorted stocks, or recommended selling had already been burned.
- Amateur Trading – The most frustrating kind of trading for financial advisors and financial planners. This kind of trading is based upon a gut feeling, or “knowing” something that everyone else already knows. This is the kind of trading where someone buys Apple stock because iPhones are huge right now. Everyone else knows that too, and it’s already priced into the stock. This kind of trading happens most frequently to household names, like Apple, Microsoft, Tesla, and so on. This kind of trader somehow thinks he “knows” something, usually with no research of any kind. Just kind of seeing it around is enough. This type of investing is pure luck, but it does move these stocks. Curiously, professional investors take this into account when buying and selling these same stocks trying to gauge when Main Street will make its move and trying to beat them there.
There are many other kinds of investing, but most are nuances or combinations of those above. Going forward, I’ll do what I can with some of the other types of investing, but remember they are speculative for a reason. They are the win some / lose some type of investing. You’ll need a big investing account to be able to ride out the losses.
However, if your investments are in your 401k, your IRA, or your kid’s 529 plans, you have no business doing the above investing. Those accounts should only be invested using the principals of long-term investing, asset allocation, dollar cost averaging, and rebalancing. Do not chase news or results in those accounts.