Types of Investment Strategies
When it comes to investment strategies, every investor has their own preferred methods. Whether it’s wearing a lucky hat and vetting every security to checking the news religiously. There is no necessarily right or wrong way to approach the practice. In fact, there are over half a dozen great investment strategies for investors to consider.
In short, an investment strategy is a way to define your approach and goals when buying assets. Regardless of the types of securities you purchase (bonds, stocks, etc), there are several well-known tactics. We’re going to discuss some of the more common investment strategies here.
Before you invest, you’ll want to answer a few questions about your personal situation. These will help you determine the best strategy to suit your needs. For instance, you’ll want to decide whether you want to pursue a passive or active approach. You’ll also want to decide how your approach fits in with your risk tolerance. There’s nothing worse than throwing your future into the stock market and losing everything in your 50s.
Your investment time horizon is another critical consideration — do you want children soon? Are you planning on purchasing a house? Knowing when you’ll need to have a nest egg can help you narrow down which strategies suit your financial needs.
After you’ve taken stock of your personal situation, it’s time to look at a few different investment strategies, such as:
- Growth investing, whichfocuses on putting money into companies you believe will be valuable soon
- Value investing, whichlooks to invest in undervalued equities for the long-term
- Income investing, which provides a steady source of revenue
- Momentum investing, whichinvolves hawkishly watching the market and betting on discrepancies in financial reports
- Dollar-Cost Averaging, which lowers your price-per-share costs over time by not trying to time the market
There is no one right investment strategy, nor is there an “easy” strategy. Regardless of your situation and diversification, you’re likely to come across losses in your portfolio. The trick is to find a method that earns enough interest to compensate for lost funds — and then some.
Choosing an Investment Strategy
Before you choose an investment strategy, it’s important to consider your personal factors. The answers to these questions will help narrow which strategies will be most efficient for you financially — and mentally.
Do I want a passive or active strategy?
Passive strategies are long-haul investments. The goal is to minimize spending costs while maximizing profits. You do this by buying securities with the intent of holding them for years, or even decades. Many investors believe that this method allows them to cut down on taxes, commission and purchasing costs. It may also cut down on the risks of trying to time the market.
Active strategies, on the other hand, involve trading stocks much more frequently. Typically, day traders and those who hire portfolio managers use this strategy. That’s because success hinges upon deeper focus on market trends. When correctly implemented, this method can lead to massive short-term gains. However, this strategy is also inherently riskier, as a few bad calls can wipe out a portfolio overnight.
Typically, a robust portfolio will blend both strategies. The real question for most investors is not which approach they want to take. It’s what percentage of their portfolio they want to dedicate to each.
What is my risk tolerance?
Your risk tolerance is a measure of your age and financial factors against the risk inherent in your portfolio.
Typically, advisors suggest that younger investors can handle a larger proportion of risky investments, such as stocks. Strategies such as value investing may work well for younger age groups.
Alternatively, older investors should look toward more stable but less fruitful investments, such as bonds. Income investing is one of the better strategies if you’re risk-averse. That’s because it focuses on generating a stable, but potentially reduced, income.
What is my time horizon?
Your time horizon is essentially your financial lifelong goals list. It includes the answers to questions such as:
- When do I want to buy a house?
- How close am I retiring?
- Do I want children?
- Do I have student loans / am I planning on going back to school?
Based on your answers, you may tailor your investing strategy accordingly. For instance, say you’re planning to start a family and buy a house soon. You may want a short-term strategy with larger gains. On the other hand, if you don’t want children soon, you may look toward a longer-term strategy. One that allows for slower gains but increased profits overall.
Growth investing focuses on building capital by investing in equities you believe have a high potential for increasing in price. This strategy is often used when an investor believes in the long-term value of the company underlying the security. It’s common to find growth stocks in emerging industries, such as the technology and medical sectors.
Typically, growth stocks break down into two categories:
- Short-term investments are held for less than a year. Investors select this strategy when they believe a company will see rapid gains followed by a plateau.
- Long-term investments are held for more than a year. Investors select this strategy when they believe the company will increase steadily for years or even decades.
While it may seem like a money-chasing strategy, there is actually a lot of thought that goes into growth investing. Investors have to consider the current health of the stock compared to its peers. They also consider the company’s future potential in its industry. After all, a company with no room to grow isn’t likely to see gains on its stock prices.
For instance, growth investors will ask questions not just about the company’s financial situation. They’ll also ask about the services and products it provides compared to the larger market.
If you’re looking to invest in green energy, for example, you may ask yourself if solar panels or wind energy are “the next big things.” Or, you may ask yourself if you think there is a future for AI in the financial markets before putting money into a new technology company.
You’ll also want to look at the company’s historical performance to get an idea of potential future growth. If you think that solar panels are the way to go, but Solar Power for All has a history of making bad investments, you may shy away from its stock. On the other hand, if Solar Panels United has a strong earnings trend and increasing revenue, there is a far higher chance they’ll continue to see growth in the future.
One of the immediate downsides of growth investing, regardless of the specific security, is that any company aggressively growing is likely a company not paying out dividends. Some investors may accept that trade due to the rapid increase in company value. Others may decide that a risky bet with no return in the interim is not worth it and opt for an alternative investing strategy.
Value investing — the favorite of famous investor Warren Buffet — focuses on stocks an investor believes may be currently undervalued. The allure of value investing is that when the market corrects for the undervaluation, investors can sell their stocks for much higher than they paid.
For example, let’s say that Magicians and Gizmos is trading stock at $25 per share due to current market conditions. However, you believe that the equity is actually worth closer to $75 per share. When the market realizes its mistake and the price “magically” corrects to $75, you’ll make a $50 profit on every share you purchased simply by calling it first.
This strategy partially stems from the belief that the market is irrational, which presents investors with a chance to buy stock at a “discount” and cash in on making the right call later. However, these returns may not materialize for years, which is why value investing is typically a long-haul game.
To be a successful value investor, you have to do your homework and learn not only the companies you wish to purchase, but the larger markets. This allows you to feel out when a company is underperforming compared to its competitors. When correctly implemented, studies have shown that value investing strategies outperform most growth strategies — when considered in time frames of ten years or more.
One of the issues with value investing is that the field is incredibly subjective. While there is money to be made in this strategy, it’s also possible that any investments you make on the premise of a company being “undervalued” will never see the gains you hope to achieve.
Furthermore, not everyone has the time and resources to throw into investigating every company in their portfolio. Therefore, many investors turn to the P/E (price-per-earnings) ratio to quickly diagnose companies that may be underperforming. The P/E ratio determines how much you’re paying against current earnings — the lower the P/E ratio, the less you’re paying per $1 of investment.
However, P/E ratios alone are not a guarantee of an undervalued stock. For example, this number can be falsely lowered when companies inflate their accounting numbers to show falsely high earnings. When the company corrects their forecast to actual accounts, the “value” of the company is lost (because it never existed in the first place).
Momentum investors are data-driven traders who look for patterns and discrepancies in a company’s financial data to inform their purchasing decisions. The goal is to capitalize on improperly valued equities, be they over- or undervalued. On paper, this strategy works to investors’ advantage by racking up profits over months, rather than a period of years.
Momentum investors are all about winning by betting on the numbers. As a rule, they believe that growing stocks will continue to grow, while stocks that consistently show losses will continue to lose. Their method flies in the face of the efficient-market hypothesis (EMH), which states that asset prices reflect all available information.
This investing strategy has repeatedly shown to outperform benchmarks and markets worldwide — in theory. While the buy and sell strategies on paper look to provide a large profit, in actuality, very few momentum funds prove excessively profitable.
The secret is that all of the buying and selling required with this strategy (actions such as day trading and shorting stocks are common in momentum investing) comes with high trading costs. For every stock traded, there is a broker or investment firm making a commission and taking their fees off the top.
Furthermore, many momentum investors spend inordinate amounts of time hawking the markets. While this is reasonable for brokers and other financial professionals, it’s not reasonable for most individuals who have to work at their day jobs outside of investing.
One of the most common strategies that aggressive momentum traders look to is shorting stock, as it quickly and sharply increases returns to make up for losses elsewhere. Investors utilize this strategy when they believe a stock is about to fall off a cliff.
In short, the practice works by borrowing stock at Price A, selling the stock on the market at Price A, and re-buying the same stock at a much lower Price B. However, this strategy is incredibly risky. Quite literally, it comes with unlimited downside risk.
In traditional investing, downside risk is equal to the value of your investment. However, with short selling, the potential for downside risk is exponentially increased, as there is no guarantee that the stock won’t shoot up in price rather than fall.
Let’s give an example.
Say you borrow 100 shares of Awesome Company’s stock at $1 apiece — $100 total — because you think the stock price is about to take a hit. You then turn around and sell your borrowed shares at $1 apiece. When the asset drops to $0.50 per share, you re-buy all 100 shares at the discounted price ($50 total) and “return” the shares to the lender. In this scenario, you would make $0.50 on every share of stock, or a profit of $50 (not counting trading costs).
However, the downside risk states that there’s no reason the stock you borrowed and sold couldn’t suddenly shoot up to $50 per share overnight. If this were to occur, you (the borrower) would be responsible for purchasing 100 shares at $50 (rather than $0.50) apiece so you could fulfill your debt to the lender. While this isn’t a guaranteed outcome, neither is the one in which the stock price falls rapidly.
Income investing focuses on buying securities that provide a steady source of revenue. Rather than throwing money into equities that theoretically could increase in value — thereby increasing the cash-in value of your portfolio — income investing looks toward investments that provide immediate returns.
This investment strategy can be broadly divided into two categories:
- Dividend investing. When a company pays investors some of its profits, this is called a dividend. While usually not a radical sum of money, dividends provide steady income in a volatile market.
- Bond investing. Bonds are essentially a loan you grant to an institution or government in return for guaranteed interest and principal repayment. These securities pay out consistently, which makes them attractive to income investors.
As with anything in the financial market, there is no guarantee that income investing will definitely produce returns equal to or greater than your initial investments. However, by staying away from volatile companies and electing for securities that provide quarterly payments, investors mitigate some of their risk.
Dollar-cost averaging (DCA) is a strategy that involves investing regular amounts of money in the market at regular intervals. Rather than helping investors select which securities to purchase, DCA is a tool that any investment strategy can easily utilize. The major benefit of DCA is that it prevents investors from attempting to time the market.
For instance, an investor who uses DCA may set aside $200 per month in an investment account. Whether the account is professionally or personally managed does not matter — so long as the money is regularly deposited. Once the money is set aside, the investor may select one (or a blend) of the methods above to determine which specific securities they want to purchase.
Overall, DCA is a wise investment practice for almost any investor who can’t afford to dump huge lump sums into a set of securities. Once a sustainable sum, time of month, and frequency of purchase is set, all investors have to do is select their favorite securities. Some investors may choose to purchase the same stocks every month, while others may vary their investments every few months.
The real secret to this method is that, while you may purchase securities at both high and low price points, over time you lower your average cost-per-share price.
Once you’ve narrowed down which strategy (or blend) is the most efficient for you, there are a few things you’ll need to do before you get started.
- Figure how much you can afford to invest and stick to it. Some investors may make one huge initial investment and then smaller, regular investments. Others may choose to put $100 into the market every month, regardless of performance. The important thing is that you invest, not necessarily how much (though the more you can afford, the better your returns will be).
- If you have questions about your specific financial situation, consider talking to a financial advisor. There is no one-size-fits-all investment strategy, and every person’s situation and goals are different.
- Don’t shy away from employer-sponsored retirement accounts. Just because you’re investing in the market doesn’t mean you shouldn’t also invest in statistically safer accounts such as 401(k)s and IRAs. This is another way to automate your investments and savings — and because the funds are removed pre-tax from your paycheck, you won’t even notice the money missing.
- Look to vary your investment vehicles. Throwing all of your money into stocks is a good way to get burned if you’re not careful. On the other hand, putting all of your money into bonds may provide much smaller returns in the long run.
- Know your risk tolerance. Investing is a roller coaster of emotions and potentially bad decisions. Don’t invest more than you can afford to lose in a worst-case scenario — and don’t be afraid to leap into the market again just because you made one bad call.
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Originally published at https://learn.tryq.ai.