The Three Types of Investors — Which One Are You?

It’s the question that not many people ask or know the answer to.

Should you be asking? Yes! For your wealth accumulation as an individual, you need to know what kind of investor you are.

Knowing the difference will help you make better financial decisions in the future.

To my mind, there are three main types of investors:

• Fundamental investors
• Speculators
• Arbitrage traders

So, what are the differences between the types of investors, and which is better?

Fundamental investors

The best example of a fundamental investor is Warren Buffet.

Mr Buffet pores over the financials of a company. He understands where the economy currently stands, and where it is heading, then makes a decision to invest based on all these reasons.

He then sticks with this company for decades — sometimes multiple decades.

Warren Buffet believes that the value and wealth a company generates will reward him in an ever-increasing stock price over the years. He is, of course, correct.

Warren is a long term investor. He is a fundamental investor; a person that looks at the long-term cash generated by a company’s various revenue streams.

What are revenue streams?

Every company exists by making a profit from selling a good or service.

Apple sells iPhones. They also have iMacs, watches, music, iPads and many, many other products. All these products create ‘revenue streams’ for the company.

The more revenue streams, the more money and profit a company will make.

Fundamental investors also look at the likelihood that these various revenue streams will be ‘stable for the coming years.

Why?

Because fundamental investors are looking at the future earning potential of a company based on everything they know about it right now.

Get this right and you can make an enormous amount of money. Can you imagine the returns, for instance, if you’d invested heavily in Apple just before the return of Steve Jobs?

Get it wrong, and you might be stuck with a company that continually disappoints, doesn’t grow, or worse still, goes bankrupt.

Speculators

Speculators don’t really care about the future revenue streams of a company.

They take advantage of information that will have an immediate effect on prices. They are looking at changes that last for only a few weeks, days, or even hours — perhaps just because of an interest rate decision made by the government.

These changes may only be temporary and may eventually reverse themselves, but by trading quickly, speculators can profit from short-term price changes.

Speculators really dominate short term prices and are very helpful for what I call ‘price discovery’ — how much a stock is worth at any one time, which is determined by the current (or spot) trading price. And speculators have significant influence over current trading prices.

If we only had fundamental investors, then there would be minimal trading and therefore little understanding of the ‘current price’.

Speculators really help ensure that there is an active market and make it easy to sell your shares should you be interested.

Arbitrage traders

Arbitrage trading — or relative value investing — is almost exclusively the game of the ‘big boys’.

Arbitrage trading is where people who have access to many markets would look to exploit pricing inefficiencies to make low-risk or no-risk profits.

At times you might see a stock trading on the New York Stock Exchange. The same company may also be trading on another exchange (perhaps in another country), but there is a price mismatch between these two stock prices.

Relative value investors go after that mismatch like mad. They buy the cheap and sell the expensive in massive, massive amounts.

Why? Because it’s the same stock, it has the very same underlying security.

These traders will lock in a profit at minimal or no risk to themselves.

Arbitrage traders are essential for the overall functioning of the stock market and the economy.

But the average retail investor has close to zero chance of being able to become an arbitrage trader. Don’t bother.

Which one are you?

The average investor, therefore, is either will be a fundamental investor or a speculator. But you should only ever be a fundamental investor.

Why?

For the vast majority of people, in the long run, being a fundamental investor has higher returns and lower risk.

Warren Buffett agrees. He is the quintessential fundamental investor.

A speculator isn’t even an investor — they are a trader. A trader only cares about the short term.

They are making a quick buck. Traders ignore fundamentals (mostly) and invest on emotion, on swings in the market place, on sentiment, on rumours, and on ‘gut feelings’ (among other things). Trading is an entirely different game, and it’s one I would leave to the experts.

Don’t think you can outsmart the market, don’t think it’s easy, and don’t believe you are better than the experts. Even professionals lose a lot of money.

Having said that, you still need to be very careful with which company you invest in.

You see, in reality, how do you as an average investor, feel confident in the future revenue of a company? Do you really understand, or have a feel for, the quality of the company’s management team? And just as importantly — what influence do you have on the direction of the company?

You may feel very, very confident in Apple, but are you aware of all the company’s investments, or its approach to future and potential revenues? Do you know which markets it is weak in? Or perhaps which parts of the company is poorly managed or needs to be reorganised?

All of these questions come before even thinking about their competition and rapid changes in technology.

Do you see what I mean?

I’m not saying that this information is not available. You can spend hours, days, and weeks poring over a company’s earnings, quarterly reports, and investigate the competitive landscape. In fact, that is what the big fund managers do. Their teams include some of the best analysts in the world who do this for them every day.

But as an average investor, who has the time? Who has the energy?

That is why I often suggest investors look at investing in an index or use a money manager that has low fees and a broad portfolio of investments. Check out my article on investing hacks here.

You will still be a fundamental investor, but you will be using a much safer approach.

What does all this mean?

It is crucial to be a fundamental investor.

But make sure you do your research, work with a money management expert, or simply invest in an index.

And don’t forget…

• Fundamental investing will make you a winner in the long-term.
• Research companies before investing in them.
• If you don’t have time to research, consider investing in an index or find a money manager.

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