Types of Investors on Financial Markets

Transcription

1 Types of Investors on Financial Markets The financial markets the soulless world of money ruthlessly ruled by greed and fear 1 and populated by hundreds of millions (if not billions) of investors have some specific types of investors. Consequently, there are different classifications of investors. The most typical and common differentiation is that of individual v. institutional investors. This article presents popular classifications of investors known from practice as well as literature. I hope you can identify with some of the types or possibly find a model you would like to follow. Investors can be classified by a range of different criteria. The most typical of those include: 1. Investment horizon 2. Investment strategies 3. Expectations of the direction of market price changes 4. Behavioural finance criteria These different types of classification are described in detail below. Classification of investors by investment horizon The time horizon preferred by investors can be classified as shown in Table 1. The shortest investment horizon is the domain of day-traders whose motto runs Don t sleep with a position which means that every position should be closed out before the close of trading (there are no overnight positions). This group of investors includes two sub-categories: Razors Scalpers The philosophy of both sub-categories is similar and follows the formula below (for long positions): P C C where: Z P K 1 However, Greed, in lack of another word, is good, to quote Gordon Gekko in Wall Street. 1 P a g e

2 P 0 instrument purchase price, C 1 commission on opening the position, C 2 commission on closing the position (in approximation, C 2 =C 1 ), Z profit, P K instrument sale price. Table 1. Classification of investors by investment horizon CLASSIFICATION I CLASSIFICATION II Intraday (razoring and scalping) Several sessions (swinging) Short-term 1 week 2-3 weeks 1 month 1 quarter Mid-term 6 months 1 year More than 1 year Long-term Source: Own research. If the formula is met, the investors close out positions. The amount of shaving profits is very low (as thin as the edge of a razor) ranging from ca. 0.1% to 0.3% of price P 0 per trade. Scalpers set the profit level somewhat higher, ranging from ca. 0.3% to 0.7% of price P 0 per trade. In the stock market lingo, the scalping strategy is known as the dachshund : the dachshund is a hunting dog 2 P a g e

3 whose combat tactics boil down to get to your enemy, bite off a mouthful, and run. Swingers hold a position for several sessions but no longer than five trading days. If the price of the instrument does not change significantly by then, they close out the position. The other groups of investors hold a position for a number of calendar units. Mid-term investors hold a position for a period ranging from one month to one year; long-term investors hold a position for a period ranging from one to several years. Classification of investors by investment strategy The most typical investment strategies include: Active Passive Mixed Mechanical Active strategies use a number of different methods to make investment decisions, including: Technical analysis based on instrument price charts and their interpretations addresses the question at what price to buy or to sell, or at what price to place a stop loss order; Fundamental analysis whose main objective is to calculate fair value 2 of stocks and compare it to the market value. If fair value is significantly greater than the market value (the stocks are underpriced), the investor will buy the stocks; if however fair value is significantly lower than the market value (the stocks are overpriced), the investor will sell the stocks. Where fair value is equal to the market value (the stocks are equitably priced), the investor will hold the position or sell it and invest in underpriced stocks in expectation of a higher return; Intermarket analysis involves an analysis of a segment of the financial market to make a decision in another segment, for instance where the investor analyses the interest rate market in order to buy or sell stocks or observes the forex market to buy or sell commodities. These three types of analysis are deployed by some 90% of investors, many of whom follow technical analysis methods. 3 Other types of analysis used on the financial market include: Fractal theory; Chaos theory; Portfolio theory; 2 Fair value of the stock is the equilibrium price of the stock; there are many methods of market pricing of stocks. 3 The principle is relatively simple: the shorter the investment horizon, the broader the use of technical analysis. 3 P a g e

4 Mathematical models. As for these four types of analysis, portfolio theory represents a strictly mathematical approach to portfolio structure but it is hardly effective in practice. Mathematical models, in turn, aim at expressing the change in price of the instrument as a function of multiple variables in order to determine the optimum investment and exit time. Passive strategies could be encapsulated in the well-known saying buy and hold. Investors who follow passive strategies usually have a long-term investment horizon and stay with their positions through thick and thin. The decision to sell is usually based on fundamental analysis. Mixed strategies are a combination of active and passive strategies. 4 The investor manages a part of the portfolio using a passive strategy (e.g., 80%) and the rest using an active strategy (e.g., 20%). Mechanical investing includes: 1. Fixed amount method the investor buys a block of stocks from time to time (the interval should be fixed, e.g., one month) for the same amount (e.g., PLN 1,000). As stock prices change on the market, the investor will be buying a different quantity of stocks at each time. 2. Fixed stocks quantity method the investor buys the same quantity of stocks (e.g., 10 shares of company X, 15 shares of company Y, 20 shares of company Z; in this example, the investor s portfolio includes only three companies) from time to time. 5 In this approach, the amount invested in stocks will be different at each time (as the stock price changes). 3. Fixed proportion method the investor sets the value of stocks and the value of bonds in the portfolio in the same proportion from time to time. 6 For example, the investor wants the ratio of the value of stocks to the value of bonds in the portfolio to stay at 50%. If a portfolio revision shows that the value of stocks is X% and the value of bonds is 100%-X%, the investor must sell a given proportion of the stocks (assuming that X%>50%) and invest the cash in bonds to ensure that the proportion of stocks and the proportion of bonds are equal at 50% of portfolio value each. If the proportion of stocks at the time of portfolio revision is less than 50% (i.e., X%<50%), the investor will sell a proportion of bonds and invest in stocks to ensure that the proportion of stocks and the proportion of bonds are equal at 50% each. This simple investment method allows the investor to regularly buy stocks on a bearish market and regularly sell stocks on a bullish market. 4 Literature mentions strategies including the main (passive) portfolio and auxiliary (active) portfolios. 5 The interval should be fixed, e.g. one month. 6 The interval should be fixed, e.g. one month. 4 P a g e

5 Classification of investors by expectations of future direction of market price changes This classification is mainly used with respect to day-traders and evokes the symbols of the bullish and the bearish market. Some investors believe prior to the session that the market will rise during the day they are bullish about share prices. The bulls represent the demand side of the market. Other investors believe prior to the session that the market will fall during the day they will be opening short positions to earn on the downtrend. They are bearish about the market. The bears represent the supply side of the market. Still other investors do not know how the market is going to perform during the day they are known as the sheep which roam the market saying baa baa and distracting the focused bulls and bears playing out their positions. The sheep are passive and fearfully follow the trend, inside information or market gurus. According to Elder, [t]hey sometimes put on a bull s horns or a bearskin and try to swagger. 7 They are easy to spot because they panic when the price shock comes on the financial market. Other investors are pigs or hogs they use leverage, which means that they invest other people s money. In stock market lingo, when the pigs get slaughtered, the market situation turns against such investors whose positions will be closed out and they will lose much or all of their investment or, in the worst case, end up in the red. The favourite of all investors, Gordon Gekko, used the line in the sequel to Wall Street. The Polish stock market lingo employs the term shark to refer to a very aggressive investor with massive capital. 8 A less aggressive investor may be called a pike ; the pike has impressive capital yet doesn't swim in an ocean but a local sea of investments. Investors with small portfolios are known as small fish. Finally, there are losers stock market investors who constantly lose money. Nearly every position they open generates a loss, sometimes very substantial. However, knowing a loser is definitely more beneficial than competing for the favours of a shark. While the latter is unwilling to reveal the details of his trades, the former likes to brag about positions held or about to be acquired. Smarter market players may take advantage of securities positions and trades of the losers to do the opposite and achieve great investment performance. This is something no money can buy!!! The zoological terminology also includes whales very large clients who typically use private banking service. 9 7 Elder A., Trading for a Living, John Wiley & Sons Inc., New York 1992, p No wonder that Shark (Krzysztof Majchrzak) was a principal character in Amok, one of the first movies on the restored Polish capital market. 9 There are other zoological terms used on the financial markets including the black swan, the praying mantis, small fry, the lemming, etc. 5 P a g e

6 Classification of investors by behavioural finance criteria 10 Investors may be classified by behavioural finance criteria as follows: 1. The Bargain Hunter gravitates toward stocks whose price/earnings ratio (P/E) is lower than that of the overall market. 11 He loves order and wants to categorise the world with indicators. 2. The Visionary loves change. He does not care about current financial reports and is always looking to predict the winners. He constantly controls the company: he will attend the annual meeting and ask inquisitive questions. 3. The Contrarian loves to be different and invest against the trend. He buys when everyone is selling and sells when everyone is buying. A pitfall is that the Contrarian cannot buy stocks of popular companies. The strategy is ineffective on a strongly bullish market: the Contrarian will quickly sell out the stocks that are growing popular. However, the strategy is very effective in a lateral trend. The Contrarian s main characteristic is stubbornness, sometimes very fierce stubbornness. 4. The Sentimentalist, the opposite of the Visionary, says I take it as it is. 12 He dislikes change and won t invest in new ideas. The pitfall is that the Sentimentalist cannot see the change that will topple the leaders. He sees the held position as a part of himself; to close it out would be like cutting off his right hand. 13 His main characteristic is loyalty. 5. The Sceptic is very reserved about financial reports and news. His mantra is Missing a good stock doesn t cost a penny, whereas investing in a bad stock can cost plenty. He is much better at investing in short positions and earns on a bearish market where it is much easier to spot the weaknesses of the market or the security. His key characteristic is perfectionism. However, the market is not a perfect place and nary a company is perfect. 6. The Trader focuses on short-term gains. This strategy works well on a volatile market. The Trader mainly relies on technical analysis. He must be flexible and disciplined: he often must buy stocks which have previously produced losses. A hazard to the Trader is that he must make decisions that go against his feelings. His key characteristic is boldness. 7. The Adventurist first invests and then analyses the investment. He focuses on speculative stocks. His key characteristic is self-destructiveness. 10 Based on Niederman D., The Inner Game of Investing: Access the Power of Your Investment Personality, Wiley, John & Sons, Inc., New York The pitfall is that the investor will buy stocks of weak fundamentals with low market pricing. 12 Known in the stock market lingo as falling in love with the stock. 13 It is known as the retentive personality. 6 P a g e

7 To answer the question which stocks are bought by which types of investors, the Bargain Hunter invests in under-priced stocks, the Visionary in growing companies, the Contrarian in companies that are overcoming a crisis, the Sentimentalist in good old stocks, the Sceptic in companies facing serious financial trouble (short sale), the Trader in stocks which offer gains in a short horizon, and the Adventurist in speculative stocks. However, the problem is that every investor is a combination of different styles with a predominance of one of them. You should understand your personality well to know which investment style you are comfortable with and then invest according to that style without losing sight of the other styles. After all, kung fu uses a combination of the combat techniques of the monkey, the lion and the crane; thus, your opponent (another investor) will never know for sure which style or technique you are about to use! 7 P a g e