Invstr basics: The different kinds of investment strategies
Follow tried and tested investment strategies and you can develop a healthy portfolio with impressive returns
For beginners to the markets and seasoned professionals alike, a smart investment strategy can mean the difference between establishing a strong portfolio with healthy returns, and missing out on potential gains. Or even worse, seeing an investment fall apart all together!
In this blog we will outline a few of the most well known investment strategies as popularized by some of the world’s most famous investors, and why they are beneficial for anyone who has an interest in buying stocks.
The core principle behind value investing is this: buy stocks that are trading for a cheaper price than they are really worth. By picking stocks which have strong fundamentals, but are undervalued by the market, the opportunity to make money can be far greater. By investing when the share price is comparatively low, you can then benefit as its value eventually starts to rise towards its real intrinsic value.
Finding stocks that are underpriced takes research in order to evaluate the fundamentals of the underlying company, (by looking at markers such as its price/earnings ratio and yield). It might sound like a little more work, but this method of investing can pay off nicely down the line, making an investor great returns. By holding on to an underpriced stock until its price recovers, an investor can then sell it at the top, cutting a nice profit.
Due to the fact this strategy depends on finding cheaper stocks and waiting for their price to move up to a level which reflects their underlying value, this is a ‘buy and hold’ style of investing. The time horizon (meaning how long you hold onto the investment for) can often be longer, but should the right call be made, impressive gains can be had. This was an investment technique popularized by Warren Buffet, the billionaire investor known as ‘The Sage of Omaha’, but besides him, the notable British/American investor Benjamin Graham also swore by this strategy, as he tended to buy stocks only when they were priced at two-thirds or less of their intrinsic value.
Like other strategies, growth investing is focused on the growth of an investor’s capital, but it does this through buying stocks of companies whose earnings are predicted to grow at an above-average rate compared to its sector, or the broader market as a whole.
Growth investors will look at a few factors when deciding whether a company is worth investing in. For starters, they may look at whether the business has had good earnings growth in the past, while also considering the potential for forward earnings growth in the future. To determine this, an investor might want to consider the performance of the business relative to its peers within the same sector, what it has in its product pipeline for the future and more.
Digging down a little deeper, a growth investors will want to look at the management of the company. How is it run? Does it incur large staff costs? How has certain management affected its success?
Overall, investors will look to find companies that exhibit signs of above-average growth, through revenues and profits, even if the share price appears relatively expensive in terms of price-to-earnings or price-to-book ratios. This is a key differentiator between growth and value investing, because in the latter the price is of paramount importance when choosing whether to invest or not. For growth investing however, it’s not so much about the price trading cheaply, but the potential for future gains no matter what the current price of the stock is.
A relatively riskier strategy, growth investing involves investing in smaller companies that have high potential for growth, blue chips and emerging markets.
Investing by sector
Sector investing offers targeted exposure to the stocks of companies in specific segments of the economy (such as health care, real estate or energy) and can help investors pursue growth, diversify your portfolio, and manage risks.
Investing by sector can be particularly succesful for investors who have a strong knowledge of a particular part of the economy. For example, some investors may have a stronger understanding of how banks work, so may choose to invest purely in financials, giving them a higher chance of success in finding the best possible investment options.
Some sectors may also be less volatile than others, which may appeal to investors with less of an appetite for risk and who are more focused on capital preservation (keeping what they already have). An example of a higher risk sector could be basic materials, which is the category that is involved in the discovery, development and processing of raw materials.
Some investors may favour to select investments by the region of the world they exist in. The most common example of this could be selecting between investing in emerging markets (in developing economies such as in Asia or Africa) and established markets (in fully developed economies such as those in Western Europe or the US).
Similarly to small vs large cap investing (where an investor may reap higher rewards in return for taking more risks), investing by region may present different advantages and disadvantages for an investor.
Regions in which equities are underpriced and lesser known by most investors may present great opportunities, because emerging market economies can often grow at a faster rate than their developed counterparts (similarly to small cap vs large cap stocks), thus raising prices higher and faster. However, these parts of the world may be more prone to negative external circumstances like political instability, volatile currencies or adverse weather conditions. All of these factors can influence stock prices, which can make risk-averse investors nervous!
Small cap vs Large cap
Investors can also choose to pursue a strategy that targets specific kinds of businesses. One of these is called small cap investing, an approach that favours putting money into companies with smaller market capitalization, in contrast to investing in large cap businesses.
The advantage of a strategy that focuses on small caps is that these firms tend to grow more quickly on average than their larger peers. According to a database maintained by investment research firm Morningstar, small-cap’s margin of victory over large-caps since 1926 is 2.2 annualized percentage points.
Another advantage is that smaller companies, primarily because of their lack of visibility within the investment community, often experience a disconnect between their stock prices and their fundamentals. So, just like we talked about with value investing above, by sticking with small caps, investors can often find great cheap deals where they buy strong shares for a fraction of the price of big-cap counterparts.
Small cap investing can be riskier however. There is a reason large-cap companies have reached that point – they have been warmly received by the market and are an attractive proposition for shareholders. As these businesses are already established and successful, there is less chance they could fail (which could cause an investor to lose the money they invested in it.) Conversely, small-cap companies are still in earlier stages of growth and are usually less stable and secure. Thus, buying shares in them entails more risks, though the benefits can often outweigh the drawbacks for investors with a higher risk-tolerance.
It is this riskiness that is the reason why institutional investors (investment firms that invest people’s money on their behalf), often stick to large-cap (bluechip) businesses, because they know that the money of their clients will be safer invested in these.
Other considerations – diversifying your portfolio
Portfolio diversification is a big factor to consider which can help you to keep losses to a minimum (though this is not guaranteed). Read our blog on the topic to find out more about how it can help you as an investor.
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