There are lots of very different ways to make money in the stock market. Before you look at how to start investing, it’s important to know about the different investment strategies you can use. The investing or trading style you use should make sense to you and match your personality.
In this post we are specifically looking at the different types of equity investors and traders, rather than those who trade other asset classes. Stock market participants are often divided into 3 types of investors – value, growth and dividend. This is probably overly simplistic, so we are including strategies with different time horizons and methods.
Once you know about the different types of investors and traders in the stock market, you’ll have a better idea of the right approach for you. You can then learn investing strategies to implement that approach. This will help you stay focused without trying to do everything at once. By focusing on strategies that match your personality you will increase your chances of success in the stock market.
- Investing vs. trading
- Buy and hold investors
- Value investors
- Growth investors
- GARP investors
- Dividend investors
- Momentum investors
- Trend followers
- Momentum traders
- Swing traders
- Day traders
- Short sellers
Investing vs. trading
Before we list the different types of investors and traders, it’s worth pointing out the difference between investing and trading. Investing is concerned with the value of a stock or company, while trading is concerned with the share price. The value of a company usually changes gradually over time, during which time the price can fluctuate a lot.
An investor relies on the value of a company increasing, which should also result in the price increasing. Traders are interested in changes in price that occur due to changes in supply and demand. In practice, investors have a time horizon of at least 6 months, as it takes at least that long for a company to become more “valuable”. By contrast, a trader’s time horizon can be as short as a few seconds and as long as a few months.
Buy and hold investors – Time horizon: Indefinite
If you are a buy and hold investor, you buy stocks that you intend to hold indefinitely. That doesn’t necessarily mean you will never sell a share, but your typical holding period will be as long as ten years. This suits the types of investors who want to take a long-term view, and then ignore any short-term news and price movements. If you have a very long-time horizon, you will invest in stocks in very much the same way as you would invest in a private company.
|Investment mistakes are most often made during periods of volatility. This often results in selling stocks at the worst possible time. This is avoided by buy and hold investors.||Some companies do eventually go into terminal decline. This typically occurs when a company’s products are displaced by entirely new technology. If you are a buy and hold investor, chances are that you will only realize a company is in terminal decline when the share has lost a lot of value.|
|Being able to ignore short term volatility is also less stressful.|
Personality fit: Buy and hold investing suites people who want to take a big picture, long term view. This means you will need to ignore short term fads and focus on companies that will be around for the long run. You will need to be comfortable ignoring periods of underperformance and be able to resist the urge to second guess your decisions.
Value investors – Time horizon: Long term
Value investors invest in stocks trading at a price they believe to be well below their intrinsic value. A company’s intrinsic value can be based on the value of its assets or projected cash flows. To calculate the real value of a stock you need to have a very good understanding of accounting principles and the industry in which a company operates. Deep value investors buy companies that are trading at even deeper discounts, usually as a result of carrying too much debt or requiring a complete restructuring.
|Value stocks have less downside risk because they are already “cheap”.||Value investors sometimes experience long periods of underperformance.|
|If you buy a stock at a deep enough discount, you will have a margin of safety which acts as a cushion if the outlook worsens.||Sometimes you will overlook the real reason for a stock being cheap. This is a value trap – a stock that appears cheap when its value is really declining.|
Personality fit: Value investing suits those who are happy going against the crowd. You will need to be able to act with conviction based entirely on your own fundamental analysis. You will need to be prepared to do a lot of “bottom-up” company analysis to generate investment ideas.
Growth investors – Time horizon: 2 to 10 years
Growth investors invest in companies when they believe the value of the company will increase as revenue and profits increase. Growth stocks typically trade at a premium to their asset value, which means there needs to be enough growth to offset the premium and still generate a profit. Growth investors must have a very good understanding of growth industries, products, and companies.
|Growth investing provides exposure to innovative technologies and growing markets and industries.||Growth stocks tend to trade at a premium, which means they fall further than most during corrections.|
|Growth investing has been a particularly profitable investment style in the 21stcentury.||A relatively high number of growth stocks never regain the prices they reach during market bubbles.|
Personality fit: Growth investing is all about stock picking with the future in mind. This suits the types of investors who are passionate about companies, technology and consumer trends. You will need to be comfortable both taking and managing portfolio risk.
GARP investors – Time horizon: 2 to 10 years
GARP stands for growth at a reasonable price. GARP investors try to balance the valuation with the growth prospects for a company. They know that good growth stocks are seldom cheap – but they also know there is limit to how much one should pay. So, they will buy a stock at a valuation they believe the company can grow into.
|GARP investors are less likely to be drawn into the hype that often comes with growth stocks.||It can be difficult to find the right balance between valuations and quality, as the best companies are often very expensive.|
|GARP is a more conservative strategy, but also provides exposure to growing industries.|
Personality fit: GARP suits the types of investors who are very patient and prepared to wait for great opportunities. It’s a good trade-off if you want to invest in growth companies, but want to avoid speculating.
Dividend investors – Time horizon: Indefinite
Dividend investors focus on income rather than capital gains. This means buying stocks with decent dividend yields, and cash flows that are reliable enough to ensure continued dividend payments. A popular subset of dividend investing is “dividend growth investing”. This entails looking for companies that are growing their dividends each year. Even if a company’s dividend yield is quite modest when you buy the stock, if it increases over time you can end up with a great yield a few years later.
|A diversified portfolio of dividend stocks can eventually provide you with enough income to live on.||During periods when growth stocks outperform, dividend stocks often provide lower total returns.|
|High quality companies that pay dividends typical have good profit margins and predictable cash flows. This makes them defensive as well as income-producing.||If a company doesn’t have enough cash flow to pay its dividend, the dividend may be cut. This typically results in the stock price falling too.|
Personality fit: Income investing suits people who prioritize income over capital gains. This typically means people who are retired or close to retirement age. However, it’s also a good strategy for risk averse investors.
Momentum investors – Time horizon: 6 months to 3 years
Momentum investing exploits the fact that stocks that perform well over a 6 to 12 months period often continue to perform well over the next 6 to 12 months. To reduce risk, momentum investors can buy a basket of shares with strong performance and then rebalance the basket at regular intervals.
|Momentum investing is one of the easiest investment strategies to implement.||A momentum portfolio is prone to go through periods of extreme volatility. Whenever there is a market correction, it’s the momentum stocks that tend to fall the most. You can counteract this by combining momentum strategies with more conservative strategies.|
|It also takes very little time to manage.|
Personality fit: Momentum investing is perfect for the types of investors who want to spend as little time as possible managing their portfolio. It also suits people who like to go with, rather than against, the crowd.
Trend followers – Time horizon: Any time frame from hours to years
Trend following is a systematic approach to trading. Trend followers use a set of rules regarding the price action of securities to determine entries and exits. As the name implies, trend following strategies attempt to capture persistent trends. Trend Followers use mechanical systems to buy into new trends and hold a position until the trend reverses. This approach has historically been more successful for commodities and currencies than for stocks.
|Trend following removes the ambiguity and emotion from trading decisions.||Trend following strategies do not perform well during periods of consolidation.|
|Trend following can be applied to any time frame.||While trend followers have done very well trading commodity markets, relatively few trend followers have outperformed in the stock market.|
Personality fit: Trend following suits the types of investors who prefer a systematic, unambiguous approach to investing. At the same time, trend followers need to be resilient to deal with lengthy periods of underperformance.
Momentum traders – Time horizon: Hours to weeks
Momentum traders use technical analysis to identify opportunities to trade stocks with high momentum. This approach can be applied on any time frame ranging from minutes to weeks, and can be used on the long or short side. Positions are typically held until the momentum slows or until a target price is reached.
|Momentum traders get to move capital to wherever the opportunity is at a given time.||Momentum trading is time consuming and requires you to keep track of the market at all times.|
|Trading with the trend is a lot easier for novice traders.||Like trend following, momentum trading is challenging during periods of market consolidation.|
Personality fit: Momentum trading is ideal for the types of investors who like to be actively involved at all times. However, you will also need to be disciplined and stick to a risk management framework.
Swing traders – Time horizon: Days to weeks
Swing traders attempt to capture the price movements that occur within a longer-term trend. The job of a swing trader is to identify potential turning points, and then wait for signs of a reversal. Swing traders usually trade in the direction of a primary trend, but can also trade against the trend. Profits are taken when the stock price reaches the opposite side of the trading range or trend channel.
|Swing traders have the advantage of being able to enter trades using intraday price action, while also capturing trends that take a few days or weeks to play out.||Swing trading positions are exposed to overnight gaps which carry more risk.|
|You don’t need to trade full time to be a swing trader.||Swing trading, like market timing, is an advanced trading style and may not be suitable for beginners.|
Personality fit: Swing trading is a good trading style for the types of investors who like short term trading but don’t want to trade full time. You will however need to be very organized and disciplined to make swing trading on a part-time basis work.
Day traders – Time horizon: Minutes to hours
The definition of a day trade is a trade that is entered and exited on the same day. Day traders focus on stocks that are “in play” meaning their volatility and volume are higher than normal and there’s a good chance the price can move substantially during the trading session. To generate meaningful profits from intraday price movements usually requires the use of leverage.
|If you exit all your positions before the end of the trading session you won’t have exposure to overnight gaps.||Trends often need a day or two to play out which means day traders can miss out on part of the trend they want to capture.|
|Day trading is a great way to learn quickly as you will execute more trades than other types of traders, and will get more practice in a short space of time.||Day trading requires your full attention at all times.|
Personality fit: The most important trait for day traders is the ability to focus for hours at a time. You will also need to be able to devote most of your time during the day to trading.
Scalpers – Time horizon: Minutes to hours
The term scalping means different things to different people. In some cases, it is used to refer to positions that are held for a few minutes at most. In other cases, it is used to refer to counter trend trades that are taken at price extremes. Either way, scalping generally implies short term trades with small profit targets.
|There are almost always opportunities for scalping.||Need to pay attention at all times.|
|Less time in the market means less risk.||Scalping is more of an income generating strategy than a wealth creation strategy.|
Personality fit: Scalping suits the types of investors who like active trading and using their instincts more than a clearly defined strategy. Scalping suits the investor type who prefers a less structured approach to trading.
Short sellers – Time horizon: Indefinite
When you short a stock, you borrow shares from another investor and then sell the shares you have borrowed. You then buy the shares back (hopefully at a lower price) and return them to the lender. Short selling can be incorporated with most of the trading styles mentioned here. It’s also a stock market technique in its own right and is preferred by some types of investors. Short sellers use either technical analysis, fundamental analysis, or a combination of the two to identify opportunities.
|Short selling gives you more opportunities to make money, and you can profit during a bear market.||Short squeezes can result in sudden losses. A short squeeze occurs when traders with short positions compete to close their positions, causing the price to rise rapidly.|
|A great way to manage risk with a portfolio of long-only strategies (portfolio hedging).|
Personality fit: Short selling generally requires you to be against the crowd, AND be correct in your analysis. This means it suits the types of investors who like to be contrarian, and are prepared to do a lot of research.
Conclusion: Different types of investors for success in the stock market
Now that you know about the various types of equity investors and traders, you should have an idea of the methods that make the most sense for you. There may well be more than one approach that you would like to investigate. Finding the right method is just the first step. The next step is to learn more about that method and work out how to get good at it. Paper trading with a demo account is a good way to practice and develop your edge.
It’s generally easier to start out using longer time frames and then shorten the timeframe as you become more comfortable. The shorter your timeframe, the more important skill and an edge become. Of course, there are also other asset classes, and there are investment strategies unique to each asset class. Within the stock market there are also other approaches, like ETF investing, to consider. You can also use an asset allocation strategy to combine a stock investing method with other asset classes.