What are the types of investment strategies?
The stock market is an incredible system that gives the average person an opportunity to build wealth over time, leading to a comfortable, financially free retirement. However, if you plan on getting involved, the last thing you’ll want to do is make blind investments with no rhyme or reason behind what you’re doing.
Ultimately, every stock listed on the market is unique, representing a different company with a unique business model and growth prospects. Some of these companies will succeed and provide strong long-run gains while others will fall flat, leaving investors holding nothing more than useless paper.
To ensure your investments are in companies that are most likely to help you reach your financial goals, following an investment strategy is a must.
What Is an Investment Strategy?
An investment strategy is essentially a roadmap that outlines how you’ll go about investment portfolio management. Each strategy outlines the types of investments you should be making using concepts like diversification to help reduce volatility-related risks. These strategies come with a few crucial parts:
1. Allocation Strategy
Your allocation strategy outlines how much of your money should be invested in each asset class.
Some allocation strategies are very easy to understand, drawing a broad line only between how much money should be invested in equities and how much should be invested in safe havens. Some strategies go into far more detail, outlining specific percentages of your portfolio that should be invested in different types of stocks and safe-haven investments.
2. Criteria for Picking Investments
A strong investing strategy should also include detailed criteria for how you pick your investments.
For example, if you’re a value investor, your strategy may only allow for investments in stocks that have a low price-to-earnings (P/E) ratio. On the other hand, a growth investing strategy might stipulate that you should only invest in stocks that have seen consistent growth in earnings and revenue over the past three consecutive years. More on these later.
3. Criteria for Exiting Investments
Finally, a solid investment strategy shouldn’t only tell you when to buy an asset, but also when to sell it. For example, an income investing strategy will point you toward investing in stocks with strong dividend yields. However, if the dividend yield ever falls below the minimum acceptable yield for the strategy, it’s time to exit your position.
Active vs. Passive Investing Strategies
All investment strategies will fall into one of two key categories:
Passive investing strategies are the most commonly used by individual investors, and for good reason. As their name suggests, these strategies are for investors who want to take a mostly hands-off approach, making long-term investments that require little to no work on a day-to-day basis.
The idea of passive investing is to invest in various assets and hold them for the long run. Passive investors build a diversified portfolio that makes money for them over time with little more effort than the occasional rebalancing.
Passive strategies generally stipulate the types of investments you should make, as well as when you should both enter and exit your position. They also take very little work in terms of maintenance. When practicing passive investing, the hard work will take place when you set everything up. After that, you’ll devote about an hour to occasional rebalancing.
Many employer-sponsored retirement plans are examples of passive investing — a portion of your pay automatically goes into a prescribed fund or set of funds each paycheck, with the idea that you can let this build up over your entire career.
Passive investing lets you participate in the growth of the market without devoting a lot of time and energy to it. The focus of passive investing is to allow you to build wealth in the markets over the long run rather than picking the perfect stock at the perfect time to make a quick profit.
Active investing is the hands-on approach to making money in the stock market. Active investors, also commonly known as traders, make short-term investments that are commonly guided by trading strategies based on technical analysis.
This high-risk style of investing involves analyzing historical data to determine the best market timing for each and every trade.
Active investing strategies often appeal to newcomers because, when deployed correctly, they give you the ability to earn returns far above market averages.
For example, an active investor may use technical indicators to find a stock that’s about to run higher and buy in, hoping to cash in on a quick swing trade. Choosing the right trade at the right time can yield the investor big returns in a single day, but there’s also extreme risk involved in this type of investing.
Beginners should generally avoid active investing. As appealing as quick profits are, active investing is incredibly time intensive and requires a deep understanding of the mechanics of the market to succeed. But for those with the time, discipline, and know-how, active trading can be extremely rewarding.
Growth vs. Value vs. Income Investing Strategies
Investing strategies aren’t just about taking a passive or active stance with regard to your activities in the market. Most strategies are focused on investing in one or more of three common types of opportunities. These include:
Growth investors work to beat market benchmarks by only investing in stocks that display strong growth characteristics. Those following the growth investing strategy look for companies with growth in the following areas:
- Revenue. Growth stocks represent companies that have consistently increased revenue on a year-over-year basis. A company that experiences consistent growth in revenue is one that’s likely headed in the right direction.
- Profitability. Revenue is not the same as profit. After all, if a company’s costs climb along with its revenue, profitability may be hard to come by. Investors following the growth strategy focus on companies that are experiencing strong growth in earnings, or the net profits a company enjoys after accounting for its expenses.
- Stock Price. Ultimately, investors have little control over future revenue and profitability. Instead, the value of their holdings is based on how much they can sell their shares for later. Growth investors like to see consistent growth in the value of the stocks they invest in over a long period of time.
As with any strategy, the growth strategy comes with a tradeoff. While investors look for consistent growth in revenue, earnings, and stock price, they don’t tend to be concerned with generating income from their investments. The vast majority of stocks in the growth category reinvest their earnings in order to maintain the growth, meaning they tend not to return value to investors by way of dividends and share buybacks.
Considering this, growth investors are moderate- to high-risk investors with a long-term time horizon and no need for immediate income from their investments — generally young to middle-aged investors. The primary focus for these investors is long-term price appreciation.
The strategy puts strong emphasis on paying attention to the valuation the market gives investments before purchasing them. Investors who follow the value strategy only invest in stocks that are undervalued in comparison to their peers, also known as value stocks.
Value investors use a wide range of valuation metrics to determine a company’s intrinsic value — or what they believe to be the true value or fair market value — before they invest. In doing so, these investors attempt to reduce risk and greatly improve potential profitability by buying companies that are relatively inexpensive.
Buying stocks that are essentially trading at a discount already is a low risk way to go about investing. Theoretically, imbalances in the stock market tend to work themselves out eventually. As a result, stocks with low valuations compared to their peers have a high likelihood of eventually climbing back to their true values. Value investors hope to ride the gains as an undervalued stock bounces back to a fair price.
As with other strategies, the value strategy does have a drawback to consider. Oftentimes, stocks that are trading at discounts are doing so for a reason. Perhaps the company’s industry is facing headwinds like regulatory scrutiny or rising costs. A company could be losing sales as customer tastes change, or perhaps its competitors have been steadily chipping away at its market share.
In cases where undervaluation happens for a reason, an inexpensive stock may not be as good an investment as its valuation metrics suggest. That’s why value investors spend quite a bit of time researching before they invest. Without research, the investment above could quickly become a losing bet, costing the investor money.
Value investors are willing and able to do the detailed research required to determine whether there’s a reason for the undervaluation or an anomaly taking place before purchasing each stock. These investors have a keen interest in beating market averages by taking the time for figurative coupon clipping in the market.
Finally, the income investing strategy is all about using your portfolio to generate income. This is done by focusing on stocks that are known for paying consistent and meaningful dividends.
Dividend-paying stocks tend to represent large, well-established companies that have a highly predictable business model. After all, in order to pay meaningful dividends, these companies have to be willing to return value to investors by literally sharing their earnings with them, rather than reinvesting these earnings into growth.
Because of their goal of producing income, income investors tend to avoid certain industries, like technology, that require constant large investments in innovation. Instead, they focus on stocks in sectors like energy, utilities, telecommunications, consumer staples, and real estate.
Like all other strategy types, income strategies aren’t all sunshine and rainbows. As mentioned above, investors tend to avoid “sexy” and exciting sectors like technology in favor of more stable industries. Although income-focused stocks provide a strong return of value for investors, price appreciation is generally slow and steady. While that limits drawdown risk, investors interested in fast-paced growth will be turned off by this category of stock.
As such, income investing is best suited for investors with shorter time horizons who are generally nearing or already enjoying retirement. After all, these investors often depend on the income their investments generate for them and don’t have enough time to recover if a significant drawdown were to take place.
Investment-Grade Fund Investing
No matter which strategy you follow, choosing individual stocks that fit your criteria requires research. If you’re not inclined to do this research, or don’t trust in your ability to adequately assess opportunities, consider using investment-grade funds.
There are plenty of funds focused on each of the strategies mentioned above.
For example, a value investor might choose an S&P 500 value index fund, which holds stocks listed on the S&P 500 market index that display value characteristics.
Many of these kinds of funds are passively managed and have low expense ratios, meaning they are low-cost alternatives. Moreover, these funds generally practice heavy diversification, adding a layer of protection to the overall portfolio.
There are even sub-strategies built on the idea of investing in investment-grade funds.
For example, index investing is a strategy entirely based on buying and holding investment-grade funds that track broad market indexes. Rather than focusing on investing in a particular type of stock, index investors simply own a small piece of them all.
In addition, various lazy portfolios have become popular options among passive investors. These are diversified, prebuilt portfolios of investment-grade funds that hold a desired mix of assets that you can buy and hold for the long run.
Investing without an investment strategy is like trying to go on a cross-country trip without a map. Sure, you may get from coast to coast, but it’s likely to take far longer and come with far more headaches without planning.
While there are several types of prebuilt investment strategies out there, you should always take the time to tailor your strategy to your unique needs and risk tolerance. Moreover, regardless of which strategy you choose, always remember to do your research and get to know exactly what you’re getting into when you invest your hard-earned money.