10 Ways to Trade: Finding and Developing Your Unique Investment Style
There are many ways to trade and invest, but the odds of success jump when you find the approach that suits you best.
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Most investors believe that there is one superior way to approach the stock market that will consistently outperform all other approaches. That isn’t true. The best way to trade and invest is highly subjective and depends on a variety of factors, the foremost of which are your personality, emotions, and mental models.
There are innumerable ways to approach the market, but casual market observers do not appreciate all the choices they have, because they are too busy trying to conform to conventional Wall Street wisdom. The primary view is that people are either long-term buy-and-hold investors like Warren Buffett or they are "meme" traders who are essentially gambling addicts.
The great majority of successful traders and investors are somewhere in the muddled middle. The best traders and investors develop a unique style that they refine as they become more experienced.
It is important to note that no style is inherently superior. What works best is highly subjective and will shift with market conditions. Some folks will do better as long-term investors, and some will do better as very aggressive short-term traders.
The factors that will determine the best approach for you are the level of capital you are working with, the amount of time you have to devote to the market, your tolerance for risk, and, most importantly, your emotional makeup.
If you are impulsive and impatient, then long-term buy-and-hold investing will be much harder for you than aggressive and active trading. Some folks simply do not have the emotional makeup or mindset to approach the market in certain ways, so they need to find what does work for them. There are many choices, and you can always find a niche that will work, but it still requires effort and self-awareness.
There is a hierarchy of investing and trading styles. Since there is far more capital devoted to longer-term buy-and-hold trading, that is what we tend to hear about most from traditional Wall Street and the business media. This creates the presumption that this is the "correct" way to invest; however, because the biggest and fastest gains are made in ultra-aggressive short-term trading, that is what we will hear about in social media on many websites.
There is very little public data about the returns generated by short-term traders and non-traditional investors. We only hear about giant funds that are complying with Securities and Exchange Commission regulations. There are many individual traders that consistently outperform even the best hedge funds, but we never hear about them for a variety of reasons.
The general investing and trading styles that exist can be categorized as follows:
1. Long-term Investing using Modern Portfolio Theory. Standard financial planning for most individuals involves developing a portfolio that aims to optimize returns by managing risk. It is primarily based on Modern Portfolio Theory, which has its basis in a paper by Harry Markowitz that was developed in 1952. Markowitz was later awarded the Nobel Prize for his work. The key to this approach is diversification and asset allocation. Stock selection tends to be S&P 500 names that are viewed as less risky and that will steadily produce returns over the long term. This is what most investment advisors and financial planners focus on, and this is what you see most often in the financial media.
2. The Warren Buffet approach. Warren Buffett’s approach differs from the MPT approach because it focuses much more on stock selection rather than portfolio construction. The main goal is to find a great business at an attractive valuation and then hold it for decades to benefit from compounding. Diversification is not essential. It sounds simple, but finding a small number of stocks that will do well over the very long term is very difficult.
3. Mutual Funds, Hedge Funds, and ETFs. The focus of most funds and ETFs is particular sectors, themes, and areas that don’t reflect the broad market. The best current example is the Magnificent Seven, which can be bought in an ETF like Roundhill Magnificent Seven ETF MAGS. There are many subcategories within this group, such as sector focus or style focus. An example of style focus is value, where investors seek to buy stocks that are cheap based on various financial metrics, or growth, which focuses on earnings per share acceleration. Big macro-focused funds look at taking advantage of economic changes around the world
4. Market Timers. There is a very active group of traders who are intently focused on trading market direction. They typically use index ETFs and options and are trying to anticipate what the market will do next. They are usually highly technical and rely on charts.
5. Trend-following and momentum traders. A subgroup of traders that attracts quite a bit of money is momentum and growth. Investors Business Daily is the bible for those who use the approach that combines fundamental considerations with technical setups.
6. Small-cap position trading. Small caps tend to move bigger and faster but carry very high risk, so traders that favor these names tend to be very aggressive and move very fast. The focus is on volatility and mispricing.
7. Volatility traders. A subcategory of big-cap and small-cap momentum trading is volatility trading. These trades look to catch the inevitable ups and downs in the stocks that they favor and use very short-term time frames.
8. News trading. These traders are constantly scanning the headlines and looking to trade the sharp and sudden moves created by news flow. News creates movement, and that leads to trading opportunities.
9. Algorithmic trading. A huge amount of the daily volume in the market is trading driven by computer programs. There are hundreds of different variations. Some use arbitrage approaches, some trade headlines, and some trade technical patterns. There is constant competition to stay one step ahead.
10. Day traders. The day traders are often focused on penny stocks and hot themes like quantum computing. They are now very heavily involved in bitcoin, cryptocurrencies, and meme coins, but many focus on equities with potential short-squeezes or stocks that trade like Ponzi Schemes. There is a gambling element to this trading, and the turnover is extremely high.
This is just a small sampling of the great number of investing and trading styles that exist. Many different permutations and combinations are used by active-active market participants. A favorite approach of many sophisticated investors is to maintain separate accounts for a conservative longer-term approach while also aggressively trading in very short-term time frames.
The most important consideration in finding a style is to be clear about what you are doing. The easiest way to run into difficulty is style drift, which I discussed in a recent column. Style drift tends to occur when your current style is not working that well, and you start treating your trades and investments differently. Suddenly, the short-term trade becomes an investment, or the long-term trade is dumped impulsively as market conditions shift.
One of the great challenges of developing a trading or investing style is that what works best will be highly dependent on market conditions. While you do not want to reinvent your approach every time the market shifts, you also want to be flexible enough to adapt when conditions change. It is a constant battle and is one of the key reasons that market success seems to come and go for so many market players.
Think about your style and how it will evolve as you change and how the market will change. Defining what you are going to do is the first step before you can improve on it.
At the time of publication, DePorre had no position in any security mentioned.
