Should you buy stocks or mutual funds, and how to choose between thousands of them? Should you trade on your own or hire a specialist? My book, Psychology of Investing, describes the subject in great details. Here are a few ideas from this book pertaining to stock trading.
Finding the Competitive Edge
The world of investing is a zero-sum game where you compete not only with amateur traders like you, but also with highly skilled professionals, our best and brightest who spend 60 hours a week trying to outsmart you. Besides, they possess the most advance knowledge, the fastest computers and all the greatest tools of trade available. In addition, the game of trading—like almost everything else related to money—is shamelessly rigged and not in your favor. You can only compete with them if you use a trading strategy appropriate for your personality type.
According to numerous psychological researchers, every person is born with a predisposition to specific character traits. By the time you reach adulthood, your character traits are already molded into a fixed personality with particular life coping skills. These life coping skills initiate specific patterns of behavior, ways of thinking, as well as the nature and intensity of emotional responses that determines your success or failure at various trading strategies. If you choose your investing strategy according to your personality type, you are likely to profit above average. However, if your strategy of trading is unnatural for your type, you are very likely to lose money.
Extroverted and Introverted
No one is either extroverted or introverted all the time. However, some function best in the midst of a large crowd leading a very active life most of the time. Such extroverted individuals usually possess good social skills and much prefer to work in a group setting. Most often, their creativity is expressed in the areas of leadership, communication and relationships.
Introverted individuals are at their best working alone or in small groups. Instead of relating to others, they escape into their own inner world of creative ideas. This is how they make scientific discoveries, produce technical inventions, develop new products or create original works of art. As it may have occurred to you, the degree of your introversion or extroversion determines your ability (or inability) to apply various trading strategies.
Trading for Extroverts
Extroverted people tend to have great social skills. As a result, they may be more successful in such trading strategies that involve interacting with other people. Such strategies may include, but are not limited to:
- Hiring specialists, such as stockbrokers and investment consultants.
- Investing in mutual funds, but only those whose managers are personally known to the trader.
- Trading on information or on tips received from experts.
- Trading through investment clubs.
As a general rule, typical extroverts will not be as good as typical introverts in assessing any particular stock or mutual fund through any type of research. Instead, they would have greater skills in evaluating the qualifications of a professional trader through personal contact. Once hired, this professional would assess such stocks and/or mutual funds for them.
Trading for Introverts
Introverts may be more successful with the trading strategies that involve research and study. Such strategies may include, but are not limited to:
- Following newsletters of investment gurus.
- Following a system.
- Creating your own system.
- Trading by fundamental and/or technical analysis.
- Trading by intuition.
- Applying astrology and other esoteric sciences.
- Contrarian trading.
Six Categories of Traders
All traders, beginners and professional alike, can be divided into six categories based on their innate and acquired abilities that may be transferable to trading: Loyalists, Revolutionaries, Reformers, Escapists, Followers and Mystics. Let’s see which one is yours.
Loyalists are those who support the establishment. Actually, most of them are the establishment working as executives in industry or in government. They normally are born to families that have occupied positions of power for generations. As a result, their life coping skills are more suitable to preserving what they have rather than risking their capital in risky enterprises. Therefore, they would be at their best in long-term investing in stocks of well-established companies that pay dividends. They invest in reputable mutual funds. Very rarely—of ever—do Loyalists trade solo. Almost always they hire well-established professional to do their trading for them. They would do very well with trading on inside information as long as they risk only a small portion of their capital.
Loyalists have their own limitations in trading stocks. Their portfolios perform best in a prolonged Bull Market. They normally hire only such investment advisers who share their values as well as their limitations. Neither Loyalists, nor their advisors are good at selling off before the top. As a result, many Loyalists may stay fully invested in a prolonged Bear Market.
In every functional society, there is a category of individuals whose functions include a constructive critique of the establishment. Even though these Reformers are sympathetic to revolutionary ideas, they are usually well placed on top of the social ladder, which makes them an integral part of the establishment. Reformers normally come from upper middle class. You will find them among university professors, published writers, lawyers, doctors and engineers. Due to the upbringing, education and experience, a typical Reformer has developed an expertise in sorting out various technical innovations. Therefore, Reformers would be best in trading aggressive growth stocks of young and highly innovative companies. They are also likely to profit from trading mutual funds of emerging markets. The trading strategies most suitable for Reformers may include following advice of investment newsletters and applying various economic theories. They will also do well by using fundamental and technical analysis.
There are a few around us who are unable and/or unwilling to fit into our contemporary culture in spite of their high intelligence. They always seem to be involved in an eternal conflict with authority figures. Through history, this small minority is the major force of all revolutions pushing humankind toward technical and social progress. If this is your case, you may be supersensitive to new emerging trends while such trends are still in their infancy. This will give you a great competitive edge in buying penny stocks of new start-up companies that have a fighting chance to become Googles and Microsofts of the future. Therefore, a typical Revolutionary would greatly outperform the market by buying stocks of start-up companies with a great potential way before these stocks appear on the radar screens of the analysts. Revolutionaries can also specialize in progressive industries and emerging markets. For most of them, the best trading strategies may include contrarian trading combined with fundamental and technical analysis.
Like their natural opponents, Loyalists, Revolutionaries also have their own limitations in trading stocks. Contrarian by nature, they may be driven to prove themselves right and all of us wrong. As a result, they may be tempted to buy stocks of start-up companies that will never rise, or invest in emerging markets that will never emerge. Revolutionaries are prone to make such mistakes just to do the opposite from what everyone else is doing.
Followers are warm, friendly, giving, caring, supportive, unobtrusive and non-demanding people. Their basic life coping skill is adaptation to their social environment. Followers can be ideal employees, able to accomplish any task assigned to them, as long as they work as a team and have plenty of supervision.
Unfortunately, Followers’ adaptability becomes a vice in trading. Trading on their own, they tend to follow the crowd by buying at the top and selling at the bottom while losing money in the process. In spite of this handicap, Followers can still trade successfully, but only by utilizing their greatest strength: their ability to function as a team. They would benefit the most by joining investment clubs and/or investing in mutual funds. They can also invest with a stockbroker but only if they have face-to-face contact with this person.
Naturally, Creators are those whose main function in life is to create. Their creations may include works of art, if they are artistically inclined. Technically inclined Creators are normally involved in fixing things, technical inventions and scientific research. A typical Creator does not want to bother with anything except their creations. Therefore, the best trading strategy for them is investing in mutual funds. Most Creators would also need an investment counselor as well to keep at least some of their attention on their investments. There are exceptions however. A small percentage of Creators exhibits strong interest in trading stocks. If this is your case, you are more likely to succeed by using technical analysis or trade by your own theory.
Mystics are those who tend to escape the pressure of modern life into their own inner world of devotional and/or spiritual practices. Many Mystics have extraordinary intuition, which can be applied in buying and selling stocks. Unfortunately, it is really hard for a typical Mystic to pay attention consistently to such crude and mundane things like money. Well, unless they invest with a partner who is able to keep their attention on their investment. If such a partner is not available, Mystics may still invest in mutual funds. They can also follow advice of investment consultants. They will have to use their intuition in choosing such funds and/or consultants.
For more information on the subject, consult my book, Psychology of Investing.