4 Key Investment Strategies to Learn Before Trading – Investopedia
An investment strategy is a set of principles that guide investment decisions. There are several different investing plans you can follow depending on your risk tolerance, investing style, long-term financial goals, and access to capital,
Investing strategies are flexible. If you choose one and it doesn’t suit your risk tolerance or schedule, you can certainly make changes. However, changing investment strategies come at a cost. Each time you buy or sell securities—especially in the short-term in non-sheltered accounts—may create taxable events. You may also realize your portfolio is riskier than you'd prefer after your investments have dropped in value.
Here, we look at four common investing strategies that suit most investors. By taking the time to understand the characteristics of each, you will be in a better position to choose one that’s right for you over the long term without the need to incur the expense of changing course.
Before you begin to research your investment strategy, it's important to gather some basic information about your financial situation. Ask yourself these key questions:
Even though you don’t need a lot of money to get started, you shouldn’t start investing until you can afford to do so. If you have debts or other obligations, consider the impact investing will have on your short-term cash flow before you start putting money into your portfolio.
Make sure you can afford to invest before you actually start putting money away. Prioritize your current obligations before setting money aside for the future.
Next, set out your goals. Everyone has different needs, so you should determine what yours are. Are you saving for retirement? Are you looking to make big purchases like a home or car in the future? Are you saving for your or your children’s education? This will help you narrow down a strategy as different investment approaches have different levels of liquidity, opportunity, and risk.
Next, figure out what your risk tolerance is. Your risk tolerance is determined by two things. First, this is normally determined by several key factors including your age, income, and how long you have until you retire. Investors who are younger have time on their side to recuperate losses, so it’s often recommended that younger investors hold more risk than those who are older.
Risk tolerance is also a highly-psychological aspect to investing largely determined by your emotions. How would you feel if your investments dropped 30% overnight? How would you react if your portfolio is worth $1,000 less today than yesterday? Sometimes, the best strategy for making money makes people emotionally uncomfortable. If you're constantly worrying about the state of possibly losing money, chances are your portfolio has too much risk.
Risk isn't necessarily bad in investing. Higher risk investments are often rewarded with higher returns. While lower risk investments are more likely to preserve their value, they also don't have the upside potential.
Finally, learn the basics of investing. Learn how to read stock charts, and begin by picking some of your favorite companies and analyzing their financial statements. Keep in touch with recent news about industries you're interested in investing in. It's a good idea to have a basic understanding of what you're getting into so you're not investing blindly.
Value investors are bargain shoppers. They seek stocks they believe are undervalued. They look for stocks with prices they believe don’t fully reflect the intrinsic value of the security. Value investing is predicated, in part, on the idea that some degree of irrationality exists in the market. This irrationality, in theory, presents opportunities to get a stock at a discounted price and make money from it.
It’s not necessary for value investors to comb through volumes of financial data to find deals. Thousands of value mutual funds give investors the chance to own a basket of stocks thought to be undervalued. The Russell 1000 Value Index, for example, is a popular benchmark for value investors and several mutual funds mimic this index.
For those who don’t have time to perform exhaustive research, the price-earnings ratio (P/E) has become the primary tool for quickly identifying undervalued or cheap stocks. This is a single number that comes from dividing a stock’s share price by its earnings per share (EPS). A lower P/E ratio signifies you’re paying less per $1 of current earnings. Value investors seek companies with a low P/E ratio.
Value investing is best for investors looking to hold their securities long-term. If you're investing in value companies, it may take years (or longer) for their businesses to scale. Value investing focuses on the big picture and often attempts to approach investing with a gradual growth mindset.
People often cite legendary investor Warren Buffett as the epitome of a value investor. Consider Buffett’s words when he made a substantial investment in the airline industry. He explained that airlines “had a bad first century.” Then he said, “And they got that century out of the way, I hope.” This thinking exemplifies much of the value investing approach: choices are based on decades of trends and with decades of future performance in mind.
Over the long-run, value investing has produced superior returns. However, value investing has seen prolonged periods where it has underperformed growth investing. One study from Dodge & Cox determined that value strategies have lagged behind growth strategies for a 10-year period during three periods over the last 90 years. Those periods were the Great Depression (1929-1939/40), the Technology Stock Bubble (1989-1999), and the period 2004-2014/15. Indeed, value investing, has consistently underperformed growth investing since 2007, producing a drawdown of more than 50% through 2020. It remains to be seen whether value stocks will regain their luster in the near future.
There's long-term opportunity for large gains as the market fully realizes a value company's true intrinsic value.
Value companies often have stronger risk/reward relationships.
Value investing is rooted in fundamental analysis and often supported by financial metrics.
Value companies are more likely to issue dividends as they aren't as reliant on cash for growth.
Value companies are often hard to find especially considering how earnings can be inflated due to accounting practices.
Successful value investments take time, and investors must be more patient.
Even after holding long-term, there's no guarantee of success – the company may even be in worse shape than before.
Investing only in sectors that are underperforming decreases your portfolio's diversification.
Rather than look for low-cost deals, growth investors want investments that offer strong upside potential when it comes to the future earnings of stocks. It could be said that a growth investor is often looking for the “next big thing.” Growth investing, however, is not a reckless embrace of speculative investing. Rather, it involves evaluating a stock’s current health as well as its potential to grow.
A drawback to growth investing is a lack of dividends. If a company is in growth mode, it often needs capital to sustain its expansion. This doesn’t leave much (or any) cash left for dividend payments. Moreover, with faster earnings growth comes higher valuations, which are, for most investors, a higher risk proposition.
While there is no definitive list of hard metrics to guide a growth strategy, there are a few factors an investor should consider. Growth stocks do tend to outperform during periods of falling interest rates, as newer companies can find it less expensive to borrow in order to fuel innovation and expansion. It’s important to keep in mind, however, that at the first sign of a downturn in the economy, growth stocks are often the first to get hit.
Growth investors also need to carefully consider the management prowess of a business’s executive team. Achieving growth is among the most difficult challenges for a firm. Therefore, a stellar leadership team is required. At the same time, investors should evaluate the competition. A company may enjoy stellar growth, but if its primary product is easily replicated, the long-term prospects are dim.
Growth investing is inherently riskier and generally only thrives during certain economic conditions. Investors looking for shorter investing horizons with greater potential than value companies are best suited for growth investing. Growth investing is also ideal for investors that are not concerned with investment cashflow or dividends.
According to a study from New York University’s Stern School of Business, “While growth investing underperforms value investing, especially over long time periods, it is also true that there are sub-periods, where growth investing dominates.” The challenge, of course, is determining when these “sub-periods” will occur. While it's inadvisable to try and time the market, growth investing is most suitable for investors who believe strong market conditions lay ahead.
Because growth companies are generally smaller and younger with less market presence, they are more likely to go bankrupt than value companies. It could be argued that growth investing is better for investors with greater disposable income as there is greater downside for the loss of capital compared to other investing strategies.
Growth stocks and funds aim for shorter-term capital appreciation. If you make profits, it'll usually be quicker than compared to value stocks.
Once growth companies begin to grow, they often experience the sharpest and greatest stock price increases.
Growth investing doesn't rely as heavily on technical analysis and can be easier to begin investing in.
Growth companies can often be boosted by momentum; once growth begins, future periods of continued growth (and stock appreciation) are more likely.
Growth stocks are often more volatile. Good times are good, but if a company isn't growing, its stock price will suffer.
Depending on macroeconomic conditions, growth stocks may be long-term holds. For example, increasing interest rates works against growth companies.
Growth companies rely on capital for expansion, so don't expect dividends.
Growth companies often trade at high multiple of earnings; entry into growth stocks may be higher than entry into other types of stocks.
Momentum investors ride the wave. They believe winners keep winning and losers keep losing. They look to buy stocks experiencing an uptrend. Because they believe losers continue to drop, they may choose to short-sell those securities.
Momentum investors are heavily reliant on technical analysts. They use a strictly data-driven approach to trading and look for patterns in stock prices to guide their purchasing decisions. This adds additional weight to how a security has been trading in the short term.
Momentum investors act in defiance of the efficient-market hypothesis (EMH). This hypothesis states that asset prices fully reflect all information available to the public. A momentum investor believes that given all the publicly-disclosed information, there are still material short-term price movements to happen as the markets aren’t fully recognizing recent changes to the company.
Despite some of its shortcomings, momentum investing has its appeal. Consider, for example, that The MSCI World Momentum Index, which has averaged annual gains of 10.75% since its inception (in 1994) through June 2022, compared to 7.59% for its benchmark over the same period.
Traders who adhere to a momentum strategy need to be at the switch, and ready to buy and sell at all times. Profits build over months, not years. This is in contrast to simple buy-and-hold strategies that take a "set it and forget it" approach.
In addition to being heavily active with trading, momentum investing often calls for continual technical analysis. Momentum investing relies on data for proper entry and exit points, and these points are continually changing based on market sentiment. For those will little interest in watching the market every day, there are momentum-style exchange-traded funds (ETFs).
Due to its highly-speculative nature, momentum investing is among the riskiest strategies. It's more suitable for investors that have capital they are okay with potentially losing, as this style of investing most closely resembles day trading and has the greatest downside potential.
Higher risk means higher reward, and there's greater potential short-term gains using momentum trading.
Momentum trading is done in the short-term, and there's no need to tie up capital for long periods of time.
This style of trading can be seen as simpler as it doesn't rely on bigger picture elements.
Momentum trading is often the most exciting style of trading. With quick price action changes, it is a much more engaging style than strategies that require long-term holding.
Momentum trading requires a high degree of skill to properly gauge entry and exit points.
Momentum trading relies on market volatility; without prices quickly rising or dropping, there may not be suitable trades to be had.
Depending on your investment vehicles, there's increased risk for short-term capital gains.
Invalidation can happen very quickly; without notice, an entry and exit point may not longer exist and the opportunity is lost.
Dollar-cost averaging (DCA) is the practice of making regular investments in the market over time and is not mutually exclusive to the other methods described above. Rather, it is a means of executing whatever strategy you chose. With DCA, you may choose to put $300 in an investment account every month.
This disciplined approach becomes particularly powerful when you use automated features that invest for you. The benefit of the DCA strategy is that it avoids the painful and ill-fated strategy of market timing. Even seasoned investors occasionally feel the temptation to buy when they think prices are low only to discover, to their dismay, they have a longer way to drop.
When investments happen in regular increments, the investor captures prices at all levels, from high to low. These periodic investments effectively lower the average per-share cost of the purchases and reduces the potential taxable basis of future shares sold.
Dollar-cost averaging is a wise choice for most investors. It keeps you committed to saving while reducing the level of risk and the effects of volatility. Most investors are not in a position to make a single, large investment. A DCA approach is an effective countermeasure to the cognitive bias inherent to humans. New and experienced investors alike are susceptible to hard-wired flaws in judgment.
Loss aversion bias, for example, causes us to view the gain or loss of an amount of money asymmetrically. Additionally, confirmation bias leads us to focus on and remember information that confirms our long-held beliefs while ignoring contradictory information that may be important. Dollar-cost averaging circumvents these common problems by removing human frailties from the equation.
In order to establish an effective DCA strategy, you must have ongoing cashflow and reoccurring disposable income. Many online brokers have options to set up reoccurring deposits during a specific cadence. This feature can then be adjusted based on changes in your personal cashflow or investment preference.
DCA can be combined with the other strategies mentioned above.
During periods of declining prices, your average cost basis will decrease, increasing potential future gains.
DCA removes the emotional element of investing, requiring reoccurring investments regardless of how markets are performing.
Once set up, DCA can be incredibly passive and require minimal maintenance.
DCA can be difficult to automate especially if you are not familiar with your broker's platform.
During periods of declining prices, your average cost basis will decrease, increasing your future tax liability.
You must have steady, stable cashflow to invest to DCA.
Investors may be tempted to not monitor DCA strategies; however, investments – even ones automated – should be reviewed periodically.
If you've narrowed down a strategy, great! There are still a few things you'll need to do before you make the first deposit into your investment account. First, figure out how much money you need start investing. This includes your upfront investment as well as how much you can continue to invest going forward.
You’ll also need to decide the best way for you to invest. Do you intend to go to a traditional financial advisor or broker, or is a passive, worry-free approach more appropriate for you? If you choose the latter, consider signing up with a robo-advisor.
Consider your investment vehicles. Cash accounts can be immediately withdrawn but often have the greatest consequences. 401ks can't be touched until you retire and have limited options, but your company may match your investment. Different types of IRAs have different levels of flexibility as well.
It also pays to remain diversified. To reduce the risk of one type of asset bringing down your entire portfolio, consider spreading your investments across stocks, bonds, mutual funds, ETFs, and alternative assets. If you’re someone who is socially conscious, you may consider responsible investing. Now is the time to figure out what you want your investment portfolio to be made of and what it will look like.
When choosing your investment strategy, answer each of these questions:
The best investment strategy is the one that helps you achieve your financial goals. For every investor, the best strategy will be different. For example, if you're looking for the quickest profit with the highest risk, momentum trading is for you. Alternatively, if you're planning for the long-term, value stocks are probably better.
A general investment strategy is formed based on your long-term goals. How much are you trying to save? What is your timeline for saving? What are you trying to achieve? Once you have your financial goals in place, you can set target performance on returns and savings, then find assets that mesh with that plan.
For example, your goal may be to save $1,000,000. To achieve this goal, you must invest $10,000 per year for 29 years and achieve 8% annual returns. Armed with this information, you can analyze various historical investment performance to try and find an asset class that achieves your strategic target.
Beginners can get started with stocks by depositing funds in a low-fee or no-fee brokerage firm. These brokerage companies will not charge (or issue small charges) when the investor deposits, trades, or withdraws funds. In addition to getting started with a brokerage firm, you can leverage information on the broker's website to begin researching which asset classes and securities you're interested in.
The decision to choose a strategy is more important than the strategy itself. Indeed, any of these strategies can generate a significant return as long as the investor makes a choice and commits to it. The reason it is important to choose is that the sooner you start, the greater the effects of compounding.
Remember, don’t focus exclusively on annual returns when choosing a strategy. Engage the approach that suits your schedule and risk tolerance. With a plan in place and goal set, you’ll be well on your way to a long and successful investing future!
CNBC. "Warren Buffett: I Like Airlines Because They Just 'Got a Bad Century Out of the Way.'"
Dodge & Cox. "Staying the Course in Value Investing," Page 1.
Arnott, Robert D., et al. "Reports of value’s death may be greatly exaggerated." Financial Analysts Journal, vol. 77, no. 1, 2021, pp. 44-67.
Maloney, Thomas, and Tobias J. Moskowitz. "Value and Interest Rates: Are Rates to Blame for Value’s Torments?." The Journal of Portfolio Management, vol. 47, no. 6, 2021, pp. 65-87.
New York University, Stern School of Business. "Growth Investing: Betting on the Future?," Page 2.
MSCI. "MSCI World Momentum Index (USD)."
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