Finding Your Niche in the Stock Market
There’s more than one way to make money in the stock market. The key is to find a method that fits your personality, focus on that method and get good at it.
These are some of the common approaches, their pros, cons and the type of personality they suit. They are listed in order from long term, investment focused styles down to short term trading focused styles.
(Hover over underlined terms for definitions.)
Buy and hold investors do just that. They buy companies they plan to hold indefinitely and are prepared to weather any storms along the way.
Time frame: Indefinite
Pros: Buy and holders don’t get shaken out of positions by volatility and negative price movements and, provided the company doesn’t go into permanent decline, this is often the best strategy. Also, long term positions don’t require constant monitoring.
Cons: Potential for permanent loss of capital. If a company goes into perpetual decline due to bad management or being eclipsed by new technology the investor may never recover their investment.
Personality fit: Buy and hold investing is all about investing in industries and companies that will be around for a long time. This requires an understanding of industries, technology and economics.
Value investors buy companies that they believe are trading at a significant discount to their intrinsic value. This requires a good understanding of how to value an asset and of the underlying business and where it is likely to be in the future.
Time frame: 2-10 years
Pros: Buying a share at a discount to its intrinsic value should give you a margin of safety. Value investing is more defensive than other styles of investing as value shares don’t have excessive growth priced into them.
Cons: Sometimes cheap companies remain cheap or get even cheaper. There is no guarantee that the market will recognize the value you see in the business. While the intrinsic value may eventually be realized, the profit may be lower than the opportunity cost of investing elsewhere.
Personality fit: Value investing suits those who are contrarian in nature with a good understanding of valuation. As a value investor you are going against the market so you need to do your research – you need to be able to spot value traps and the potential for write-downs. Above all, you need patience and the ability to act with conviction.
Deep value investors buy shares at an even greater discount to fair value. This requires even more technical expertise, conviction and patience. Deep value opportunities often appear priced for bankruptcy and offer potential returns far greater than the capital invested.
Growth investors focus on the potential growth of a company. If a company can grow earnings at a good rate for a few years, a share price which today might look expensive can turn out to be a bargain. Growth investors will typically hold investments as long as they believe the growth story to be valid.
Time frame: 1-5 years
Pros: Exposure to growing industries and disruptive technology.
Cons: Growth shares tend to price in years of growth and when that growth slows the share price has to give up all that extra priced in growth. During market corrections growth shares often fall the most. Dealing with volatility is difficult as you will usually only know after the fact whether a company could maintain its growth trajectory.
Personality fit: As a growth investor you need to be interested in technology, innovation and consumer trends. You will also need to be comfortable taking risk, making mistakes and recognising when you have made a mistake.
Growth at a reasonable price (GARP) investors try to find a balance between growth and value. They know it’s not often you get to buy a company with strong earnings growth at a bargain price. They are therefore prepared to pay for growth but are careful not to overpay.
Time frame: 1-5 years
Pros: More conservative than pure growth or momentum investing.
Cons: The better the perceived prospects for a company the more expensive the share is likely to be
Personality fit: This style of investing is less contrarian than value investing, but more conservative than pure growth investing.
Momentum Investors buy a basket of the shares with the strongest price performance over a specific time frame, and then hold those shares for a predefined period. The logic is that shares that have performed well are likely to continue performing well or at least reasonably for a while.
Time frame: 6 months-2 years.
Pros: Straightforward, unambiguous and not very time consuming.
Cons: You will from time to time be exposed to large drawdowns in specific shares. For this reason, you should spread the risk over a basket of shares.
Personality fit: If you like to go with, rather than against, the herd and you don’t have a lot of time to devote to investing this is a good strategy for you.
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 shares.
Time frame: Weeks to years.
Pros: Trend following takes the emotion out of investing as all trades are generated using a system.
Cons: Trend following systems have large drawdowns from time to time and lots of whipsaws.The win rate for these systems is often very low with lots of small losses and a few big gains.
Personality fit: You will also need the resilience and confidence in your system to continue executing trades after long streaks of losing trades. You also need to be comfortable with having a low win rate – most of your trades will lose money.
Momentum Traders trade shares with high relative momentum. They will usually hold a position until a predefined target is reached or until the momentum slows. Momentum traders usually use chart patterns to find shares with a high probability of reaching a target, and employ stop losses to limit risk.
Time frame: Hours to months.
Pros: If executed well, momentum trading can be a very efficient way to allocate capital.
Cons: Depending on the time frame, momentum trading can require a lot of time and patience waiting for setups. During periods of market consolidation, momentum trading is often unprofitable.
Personality fit: Momentum trading is perfect for those who don’t like missing out on any move in the market. But, you do need the patience to wait for the right signal and not take marginal trades.
Swing traders attempt to trade the rhythm of the market within a trend. They try to trade as the momentum changes from negative to positive and visa verse.
Time frame: Hours to weeks.
Pros: Swing trading when executed well can combine the best of day trading and momentum trading. You can trade high-risk reward setups, but you also ride the trend longer than a day trader can.
Cons: Swing trading is time-consuming as the window of opportunity can be narrow. You need to be plugged into the market at all times.
Personality fit: As a swing trader you need to have a good feel for the market and an understanding of supply and demand. Swing trading is suited to those who like to use their instincts as much as a system.
Day traders enter and exit trades on the same day. They use numerous strategies to profit from intraday trends and usually use leverage to capitalise on small moves.
Time frame: Minutes to hours
Pros: Day trading allows the use of more leverage as the risk per trade is usually lower. Day traders are not exposed to overnight gaps.
Cons: Requires full-time attention.You will often miss out on the full extent of a trend by closing a trade at the end of the day. Trading costs make up a far larger part of a day trader’s P&L, and they therefore usually only trade instruments with low commission rates.
Personality fit: The first requirement is time. DayTrading is a full-time job, not a hobby. Secondly focus, resilience and discipline.
Scalping is a term you will also hear from time to time. Scalpers attempt to make quick profits by trading within a channel or by looking for a reversion to the mean or away from a support or resistance level.
Time frame: Minutes to hours
Pros: Scalpers can make money under most market conditions by moving from one time-frame to another.
Cons: Scalping requires full-time attention because profits are small and losses must be kept small too.
Personality fit: Scalping is perfect for those who like to be active all the time.
Short selling can be used in all the trading styles above, but requires very careful risk management as potential losses can be unlimited.
These are the most common investment and trading styles. But remember, finding a style that works for you is only the first step. You also have to get good at that particular style and work out what your edge is. The shorter the timeframe, the more important skill and having an edge become. It’s best to start out with a longer time frames and move to a shorter time frame as you become more comfortable with your style.