Why should you care?
Knowing what kind of investor you are is surprisingly important. In fact, it can often make the difference between under- and over-performance in the market. Why?
Because different investor types require different investing strategies. If your strategy doesn't match your type, you will be ineffective and frustrated. On the other hand, if you take just a little time to thoughtfully match your strategy with your type, things will go much more smoothly, and you will be able to get the most mileage out of your natural skills and abilities.
How do you figure out what your type is?
A good place to start is by asking yourself the following questions.
- Am I a do-it-yourself type, or would I rather delegate this to someone else?
- Do I have the time, the desire, and the patience to learn the necessary skills to excel at investing?
- Am I willing to commit fully to this effort, and stick with it to the end?
- Do I have the stomach to handle the roller coaster ride that comes with investing?
- What's my goal: Beat the market? Just match it? Maximize income? Maximize growth? Enjoy the thrill of speculating? Protect what I already have?
If you answer these 5 questions honestly, you will be well on your way to defining (or discovering, as the case may be), your "natural" investor type.
A real case study that may help shed some light on this topic
A quick review of a recent case study might help bring this idea into focus. About six months ago a young man in his mid-20s approached me for coaching help. He wanted to learn how to be a successful day trader.
During the initial interview, I learned that he was exceptionally smart. He was committed to this endeavor, and he was willing to do whatever it took to succeed.
After probing a little further, I learned that he only had $23,000 to invest. He needed about twice that amount to secure a spot in a graduate-level engineering program at M.I.T. He considered his options and decided that day trading was a good way to double his money in one year or less. He had friends who bragged about how much money they were making as day traders.
I am not a big fan of day trading. I have coached people on how to do it, but very few of them are able to pull it off. It takes lots of capital, and lots of time to learn how to invest this way. And my young prospect had neither.
It also takes nerves of steel, and a willingness to tolerate the pain of your positions being underwater immediately after you put them on. This young man didn't have the stomach for that. He assumed that his skills as an engineer would allow him to design a trading system that kept losses to a minimum. I think most day traders believe this.
After trying unsuccessfully to talk him into a less risky strategy, I politely turned him down as a coaching client. The strategy he wanted clearly did not match his investor type. He was conservative and cautious, but day trading is aggressive and risky.
Now let's drill down a little further into the components that make up your investor type. I often refer to this as your "investor personality." It's the sum total of several character traits that inform how you think and make decisions under uncertainty, which is exactly what the stock market demands.
Elements of an Investor Personality
Your investor personality is a combination of character traits, natural abilities, and limitations that inform how you think and make decisions about financial risk. For example, the young man who wanted to be a day trader was very conservative when it came to handling losses. But he was also exceptionally bright. And he was a little naive when it comes to expectations about his chances of success.
Below is a list of character traits that make up your investor personality. Some are helpful, and some are not. Try to discern the difference between the two. The list is not exhaustive, but it should give you a sense of the big picture.
- temperament - patience, determination, stamina, courage, impulsiveness
- attitude - curiosity, adaptability, hubris, overconfidence, humility
- decision style - shoot-from-the-hip, careful research, seeking out contra opinions
- intellectual capacity - high I.Q. is better than low, but can also lead to hubris
- mindset - beliefs, assumptions, biases, preconceived notions, stubbornness
- emotional mettle - how will you react to a market that goes against you?
- susceptibility to influence - can you resist the temptation of shiny objects being dangled in front of you?
The last step in this exercise is to identify some common investor types. This is my own list, and it's based on my experience working with hundreds of investors and coaching clients.
I divide the different investor types into three broad categories: Active, Passive, and Hybrid. Let's start with the Active category. Active investors are those who try to "beat the market" by deviating from the passive, "buy-and-hold low-cost, diversified index funds strategy."
Active investors come in several shapes and sizes.
- Stock pickers - these folks believe that they have some kind of an edge over the rest of the investor community. Better information, higher I.Q., superior strategy, etc.
- Fund pickers - believe they can identify which mutual funds or ETFs will outperform the market in the near future.
- Performance chasers - look at past performance and make a wager that the best performing funds will continue their winning ways in the future.
- System hoppers - impatient optimists. Fall for one shiny object trading system after another, and abandon them at the first sign of trouble.
- Market timers - believe they can get out of the market before it craters, and then get back in before it takes off again.
Passive investors also come in several shapes and sizes.
- Traditional passives - buy-and-hold diversified portfolios of low cost index funds
- Passive tilters - deviate from conventional asset allocation by over-weighting the ones they like and under-weighting the ones they don't. Pretty similar to active investing.
- Passive in name only (PINO) - Invest only in index funds, but actively jump around from one asset class to the next, depending on what they think might happen next.
Hybrid Investors have the best of both worlds
- A "core" portfolio of 80% or so of their funds in a traditional passive strategy
- A "satellite" portfolio of 20% or so of their funds in more speculative investments like specialty ETFs or individual stocks.
- Hybrid investors tend to outperform both active and passive types.
Some final thoughts
Giving some thought to what kind of investor you are is not simply an idle exercise. It's not akin to navel-gazing or self-psychoanalysis. There is something of real value to be gained.
I will go into this in more detail in a follow-up article, but here's a preview:
- Only half of all adults in the U.S. have money invested in the market.
- Most of the invested adults just have retirement plans, like IRAs, 401(k)s, and the like. They don't invest in a taxable brokerage account.
- In these retirement plans, the money is mostly invested in mutual funds and ETFs.
- Only 13% of adults invest directly in the stock market by picking individual stocks.
- Based on my own experience, of the 13% who pick stocks, about one-in-ten have what it takes to succeed at it.
What I am saying is that most of the money that's invested in the market is being managed by large institutions like mutual funds, pension plans, foundations and endowments, etc. Very little is controlled by individuals who are trying, either on their own or with the help of some type of agent, to beat the market.
It can be done, but not without serious self-awareness and some key skills.