Market participants tend to have very strong opinions about what approach to the market is best. Buy-and-hold investors think that hyperactive day traders are wasting their time with the constant action while aggressive short term traders believe long term investors are doomed to substantial underperformance.
The truth is that no approach to the market is inherently superior. What works best is highly subjective and is a function of a variety of factors such as the amount of time invested and the level of research that is done, but the most important factor in finding the right trading or investment approach is temperament. If an approach doesn't feel right or make sense to you, then it is going to be difficult to make it really work.
The first step to finding your style is to understand the various approaches to the market. There are some basic styles and then an endless number of variations, permutations and combinations of the styles. Ultimately the goal is to come up with an approach that is uniquely yours that fits your personality, temperament, time availability and reasoning abilities.
Long Term Buy-and-Hold
Most casual market observers think of investing as holding a portfolio of stocks for the long term. They see Warren Buffett as the model for building great wealth. The irony is that the vast majority of the business media are focused on very short term movement in the stock market. If you are a long term investor that closely follows stock market coverage you will receive the message that you should be constantly changing your viewpoints and doing something different. Typically, that is counterproductive.
Long term investing is powerful primarily because of the impact of compounding. Sticking with a good long-term investment will produce great wealth because compounding returns without paying taxes on them will pay off so well 10 or 20 years down the road.
There are two major problems with the approach. First you must be in the right stocks. If a stock doesn't rise over time there is no compounding effective. If you are in the wrong stocks, holding them for the long term is the worst thing you can do.
The second problem with this approach is that there can be very long periods of time when there are poor returns. Buffett himself has gone a decade or more with very poor returns at times. It hasn't hurt him because of the giant returns compounding produced for him in his early days but other investors may not be so lucky with their timing. Not all of us of have the luxury of not touching our capital for many decades.
There are many variations of long-term investing such as buying deep value stocks or using dividend strategies. They all require longer time frames and patience.
Some market players try to address the deficiencies of long term investing by using a trend following approach. The goal is to avoid those periods of time when the market is not rising and not producing good returns. The theory is that trends tend to persist and it is possible to produce superior returns by sticking with them as long as possible and then exiting when conditions change.
The challenge of this approach is timing, but if the timing is fairly effective it can provide the same sort of compounding power that long-term investing produces. This requires more effort because not only do you need to make the right stock selection but time them in the right manner as well.
A good example of a trend following approach is the CANSLIM method popularized by Investors Business Daily. It combines technical and fundamentals to find stocks and to hold them as they trend higher.
Trend following is sometimes called position trading where the focus is on individual stocks and the time frame is intermediate.
Short Term or Day Trading
Short term and day trading are more about game theory than investing. It is an attempt to capture gains in the short term and a variety of approaches are used. Many short term traders don't even know what business the stocks they trade are engaged in. Valuation, financial statements and all those things that long term investors study in great detail are largely irrelevant.
What is most relevant in the short term trading approach is finding a catalyst that will move a stock. It may be a chart, news, overall market conditions or a variety of other factors.
This approach can produce very big gains very fast but it carries much more risk and requires much more time. If you are working a full time job and can't watch the action it is very tough to be an effective trader.
High Frequency and Computerized Trading
A variation of short term trading that now is a major factor in the market is high frequency and computerized trading. Computer programs that trade for fractions of a penny in a time frame that a human can't even recognize is now a major percentage of market volume. The goal is to exploit very short term pricing inefficiencies that are caused by a variety of factors including news.
These approaches can produce very steady returns but requires tremendous technology and programming skills. There is heavy competition and what works will shift. When the approach goes wrong the damage can be big and fast.
Once you understand the variety of ways to approach the market, the next step is to take inventory of your abilities, assets, needs and inclinations. Finding the right fit may require some trial and error and the biggest mistake most people make is to think it is going to be easy.
I'm drawn to short term trading because of the challenge. It is like a giant game of chess and there is always a new opportunity around the corner. I have the time and resources to dedicate to it and I enjoy it. I own some long-term investments but it holds little appeal to me even though they have done well because there isn't any short term reinforcement. I want to know quickly if I'm right or wrong.
Obviously you can combine a number of these approaches - and you probably should - but you will have certain biases and they will impact how effective you are. I prefer looking for smaller, lesser known stocks because I feel I have an edge. Other traders like the bigger cap, better known names because they tend to be more liquid and may not be quite as risky.
Do an evaluation of your feeling about trading and investors. What do you enjoy the most? Do you have realistic expectations? What sort of thinking makes the most sense to you?
Next week I'll delve into the details of developing a methodology that fits your particular style. In the meanwhile think about what sort of trader or investor you want to be.
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