The surge in 'meme' trading has been a hot topic in the business media recently. Traditional Wall Street tends to focus on the irrationality of the action. There is a morbid fascination with the movement, similar to watching a car wreck where it is known that the outcome is likely to be very bad. At the other end of the spectrum are many small, aggressive traders celebrating the exceptional opportunities created by the tremendous volatility. Those that are lucky enough to make the right moves will produce in a single day more gains than a balanced portfolio might produce in a year.
It is important to understand that traditional Wall Street is primarily focused on portfolio management. Individual stock picking is a very important factor for many big investors, but it must be considered in the context of risk management, diversification, and time frames shift. When these issues are confronted, the focus tends to shift away from aggressively trading fast-moving stocks in very short time frames. Trading meme stocks may be an appropriate allocation for a small number of funds, but it just isn't an effective way to manage a portfolio.
The difference in styles between trading stocks and portfolio management is often a function of account size. An individual trader with a few thousand dollars typically isn't very interested in running a balanced account with a variety of positions. They are typically looking for some big gains in short time frames, so what better way to do that than trade meme stocks? It is very risky but wiping out a small trading account isn't as life-changing as wiping out a lifetime of savings.
A money manager or big investor running seven or eight-figure accounts has to focus on capital preservation. There is a much greater emphasis on managing risk and protecting capital over producing huge one-day gains in wild stocks with no real fundamental support.
Clarity of goals is one of the most important ingredients of market success. Are you trading individual stocks to produce big returns very quickly, or are you trying to build a big portfolio that will be the foundation of your financial security in the future?
The two issues are not incompatible. Aggressive trading can be an important element of portfolio management, but diversification and time frames will impact how those trades are approached. It isn't just about producing the best returns. Tolerance for risk, time frames, and the level of effort required must also be factored in to determine what the right balance is for you.
Most investors think of the investing process as the management of a mini mutual fund. They tend to stay highly invested most of the time in what they consider to be high-quality stocks. The time frames tend to be longer, and there is a tolerance for some volatility. Quite often, the goal is to build a large nest egg for retirement many years down the road.
At the other end of the spectrum are market players focused primarily on just one thing: producing exceptional returns very quickly. They can't do that by running a traditional, big cap portfolio. Instead, they have to focus on small stocks that make bigger moves. Every day, at least a few dozen stocks move 10% or more, and that is where these traders are focused. They take high levels of risk but can produce great returns if they are skillful and work hard.
There is a middle ground between running a conservative portfolio and aggressively trading an account, but it requires a high level of effort and a clear game plan. Dedicating a portion of an account to extremely aggressive trading is often a good way to diversify. Still, short-term trading can be very distracting and makes it easy to lose focus on other stocks that may require attention.
What causes problems for many individuals is style drift. It is very easy to overtrade a longer-term portfolio or to let short-term trades turn into investments. One of the most dangerous things that traders do is keep averaging into a stock that was initially supposed to be a short-term trade. Discipline goes out the window, and suddenly this little stock is now a major investment with a high degree of risk.
Ideally, most market players should have both a long-term investment account and a trading account. The extent to which you do this will depend on how much time you have and what degree you enjoy the trading process. Effective trading requires time and energy. You have to constantly be looking for new opportunities and monitoring your ongoing trading. You can't do that passively.
The first thing that all market players should do is establish some long-term investments. I have some stocks that I've held for well over 20 years that I seldom even look at or talk about but have provided great returns. Those core holdings give me the security to trade a portion of my account much more aggressively
This approach of having both a long-term portfolio and an aggressive trading account is one of the best forms of diversification. Not only do you hold a variety of stocks, but you also have a variety of time frames and approaches. Simply holding some stocks in different sectors is not very effective as a hedge when the overall market goes through its inevitable boom and bust cycles.
Investing and trading are not mutually exclusive. On the contrary, they will complement each other well when the right balance is found and will help to reduce risk.