Investment Strategies To Learn Before Trading
The best thing about investment strategies is that they’re flexible. If you choose one and it doesn’t suit your risk tolerance or schedule, you can certainly make changes. But be forewarned: doing so can be expensive. Every purchase carries a fee. More importantly, selling assets can create a realized capital gain. These gains are taxable and therefore expensive.
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 Start
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:
- What is your current financial situation?
- What is your cost of living including monthly expenses and debts?
- How much can you afford to invest — both initially and on an on-going basis?
You don’t need a lot of money to get started, but don’t start if you can’t afford to do so.
Next, set out your goals. Everyone has different needs, so you should determine what yours are. Are you intending to save for retirement? Are you looking to make big purchases like a home or car in the future? Or are you saving for your or your children’s education? This will help you narrow down a strategy.
Figure out what your risk tolerance is. This is normally determined by several key factors including your age, income and your years to retirement. Technically, the younger you are, the more risk you can take on. More risk means higher returns, while lower risk means the gains won’t be realized as quickly. But keep in mind, high-risk investments also mean there’s a greater potential for losses as well.
Finally, learn the basics. It’s a good idea to have a basic understanding of what you’re getting into so you’re not investing blindly. Ask questions. And read on to learn about some of the key strategies out there.
Strategy 1: Value Investing
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.
As discussed above, investors can change strategies anytime but doing so — especially as a value investor — can be costly. Despite this, many investors give up on the strategy after a few poor-performing years. In 2014, for example, as Wall Street Journal reporter Jason Zweig explained, “Over the decade ended December 31, value funds specializing in large stocks returned an average of 6.7% annually. But the typical investor in those funds earned just 5.5% annually.” Why did this happen? Because too many decided to cut and run. To make value investing work, you must play the long game.
But if you are a true value investor, you need no convincing to stay in it for the long run because this strategy is designed around the idea that one should buy businesses — not stocks. That means the investor must consider the big picture, not a temporary knockout performance. People often cite legendary investor Warren Buffet as the epitome of a value investor. He does his homework — sometimes for years — but when he’s ready, he goes all in and is committed for the long-term.
Consider, for example, 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.
For those who don’t have time to perform exhaustive research, the price-earnings (P/E) ratio 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. 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.
While using the P/E ratio is a good start, some experts warn this measurement alone is not enough to make the strategy work. Research published in the Financial Analysts Journal determined that “Quantitative investment strategies based on such ratios are not good substitutes for value-investing strategies that use a comprehensive approach in identifying underpriced securities.” The reason, according to their work, is that investors are often lured by low P/E ratio stocks based on temporarily inflated accounting numbers. These low figures are, in many instances, the result of a falsely high earnings figure (the denominator). When real earnings are reported (not just forecasted) they’re often lower. This results in a “reversion to the mean.” The P/E ratio goes up and the value the investor pursued is gone.
If using the P/E ratio alone is flawed, what should an investor do to find true value stocks? The researchers suggest, “Quantitative approaches to detecting these distortions — such as combining formulaic value with momentum, quality and profitability measures — can help in avoiding these ‘value traps.’”
The message here is that value investing can work so long as the investor is (a) in it for the long-term and (b) prepared to apply some serious effort and research to their stock selection.
Those willing to put the work in and stick around stand to gain. One study from Dodge & Cox determined that value strategies nearly always outperform growth strategies “over horizons of a decade or more.” The study goes on to explain that value strategies have underperformed growth strategies for a 10-year period in just 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.
Strategy 2: Growth Investing
Rather than look for low-cost deals, growth investors want investments that offer strong upside potential when it comes to the stock’s future earnings. 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 growth investor will consider the prospects of the industry in which the stock thrives. You may ask, for example, if there’s a future for electric vehicles before investing in Tesla. Or, you may wonder if A.I. will become a fixture of everyday living before investing in a technology company. There must be evidence of a widespread and robust appetite for the company’s services or products if it’s going to grow. Investors can answer this question by looking at recent history. Simply put: A growth stock should be growing. The company should have a consistent trend of strong earnings and revenue signifying a capacity to deliver on growth expectations.
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.
Does growth investing work? As the research above indicates, value investing, over the long-term, tends to outperform growth investing. These findings don’t mean a growth investor cannot profit from the strategy, it merely means a growth strategy doesn’t usually generate the level of returns seen with value investing. But 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.
Interestingly, determining the periods when a growth strategy is poised to perform may mean looking at the gross domestic product (GDP). Take the time between 2000 and 2015, when a growth strategy beat a value strategy in seven years (2007-2009, 2011 and 2013-2015). During five of these years, the GDP growth rate was below 2%. Meanwhile, a value strategy won in nine years, and in seven of those years, the GDP was above 2%. Therefore, it stands to reason that a growth strategy may be more successful during periods of decreasing GDP.
Some growth investing style detractors warn that “growth at any price” is a dangerous approach. Such a drive gave rise to the tech bubble which vaporized millions of portfolios. At the moment, we’re in a period where growth is winning. “Over the past decade, the average growth stock has returned 159% vs. just 89% for value,” according to Money magazine’s Investor’s Guide 2018.
While there is no definitive list of hard metrics to guide a growth strategy, there are a few factors an investor should consider. Research from Merrill Lynch, for example, found that growth stocks outperform during periods of falling interest rates. It’s important to keep in mind 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. Investors must watch how the team performs and the means by which it achieves growth. Growth is of little value if it’s achieved with heavy borrowing. At the same time, investors should evaluate the competition. A company might be enjoying stellar growth, but if its primary product is easily replicated, the long-term prospects are dim.
GoPro has been a prime example of this phenomenon. The once high-flying stock has seen regular annual revenue declines since 2015. “In the months following its debut, shares more than tripled the IPO price of $24 to as much as $87,” the Wall Street Journal reported. But in recent months, the stock has traded well below its IPO price. Much of this demise is attributed to the easily replicated design. After all, GoPro is, at its core, a small camera in a box. The rising popularity and quality of smartphone cameras offer a cheap alternative to paying $400 to $600 for what is essentially a one-function piece of equipment. Moreover, the company has been unsuccessful at designing and releasing new products, a necessary step to sustaining growth.
Strategy 3: Momentum Investing
Momentum investors ride the wave. They believe winners will keep winning and losers will keep losing. Therefore, they look to buy stocks experiencing an uptrend. Because they believe losers will continue to drop, they may choose to short-sell those securities. However, short-selling is an exceedingly risky practice — more on that later.
Momentum investors could be thought of as “technical analysts.” This means they use a strictly data-driven approach to trading and look for patterns in stock prices to guide their purchasing decisions. Therefore, momentum investors are acting in defiance of the efficient-market hypothesis. This hypothesis states that asset prices fully reflect all information available to the public. It’s difficult to believe this statement and be a momentum investor given that the strategy seeks to capitalize on undervalued and overvalued equities.
Does it work? As is the case with so many other investing styles, the answer is complicated. Let’s take a closer look.
Rob Arnott, chairman, and founder of Research Affiliates researched this question. His finding: “No U.S. mutual fund with ‘momentum’ in its name has, since its inception, outperformed their benchmark net of fees and expenses.”
Interestingly, Arnott’s research also showed that simulated portfolios that put a theoretical momentum investing strategy to work actually “add remarkable value, in most time periods and in most asset classes.” However, when used in a real-world scenario, the results are poor. Why? In two words: trading costs. All of that buying and selling stirs up a lot of brokerage and commission fees.
Traders adhering 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.
For those who take lunch breaks or simply don’t have an interest in watching the market every day, there are momentum style exchange-traded funds (ETFs). These shares give an investor access to a basket of stocks deemed to be characteristic of momentum securities.
Despite some of its shortcomings, momentum investing has its appeal. Consider, for example, that “The MSCI World momentum index has averaged annual gains of 7.3% over the past two decades, almost twice that of the broader benchmark.” However, this return probably doesn’t account for trading costs and the time required for execution.
Recent research finds it may be possible to actively trade a momentum strategy without the need for full-time trading and research. Using U.S. data from the New York Stock Exchange (NYSE) between 1991 and 2010 a 2015 study found a simplified momentum strategy outperformed the benchmark even after accounting for transaction costs. Moreover, a minimum investment of $5,000 was enough to realize the benefits.
The same research found that comparing this basic strategy to one of more frequent, smaller trades showed the latter outperformed it, but only to a degree. Sooner or later the trading costs of a rapid-fire approach eroded the returns. Better still, the researchers determined that “the optimal momentum trading frequency ranges from bi-yearly to monthly,” a surprisingly reasonable pace.
As mentioned earlier, aggressive momentum traders may also use short selling as a means of boosting returns. This technique allows an investor to profit from a drop in an asset’s price. For example, the short seller — believing a security will fall in price — borrows 50 shares totaling $100. Next, the short seller immediately sells those shares on the market for $100 and then waits for the asset to drop. When it does, they repurchase the 50 shares (so they can be returned to the lender) at, let’s say, $25. Therefore, the short seller gained $100 on the initial sale, then spent $25 to get the shares back for a gain of $75.
The problem with this strategy is that there is an unlimited downside risk. In normal investing, the downside risk is the total value of your investment. If you invest $100, the most you can lose is $100. However, with short selling, your maximum possible loss is limitless. In the scenario above, for example, you borrow 50 shares and sell them for $100. But perhaps the stock doesn’t drop as expected. Instead, it goes up.
The 50 shares are worth $150, then $200 and so on. Sooner or later the short seller must repurchase the shares to return them to the lender. If the share price keeps increasing, this will be an expensive proposition.
In sum, a momentum strategy may be profitable, but not if it comes at the limitless downside risk associated with short selling.
Strategy 4: Dollar-Cost Averaging
Dollar-cost averaging (DCA) — or the practice of making regular investments in the market over time — 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, for example. This disciplined approach becomes particularly powerful when you use automated features that invest for you. It’s easy to commit to a plan when the process requires almost no oversight.
The benefit of DCA 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 is capturing prices at all levels, from high to low. These periodic investments effectively lower the average per share cost of the purchases. Putting DCA to work means deciding on three parameters: the total sum to be invested, the window of time during which the investments will be made and the frequency of purchases.
Dollar-cost averaging is a wise choice for most investors. It keeps you committed to savings while reducing risk and the effects of volatility. But for those in the position to invest a lump sum, DCA may not be the best approach.
According to a 2012 Vanguard study, “On average, we find that an LSI (lump sum investment) approach has outperformed a DCA approach approximately two-thirds of the time, even when results are adjusted for the higher volatility of a stock/bond portfolio versus cash investments.”
But most investors are not in a position to make a single, large investment. Therefore, DCA is appropriate for most. Moreover, a DCA approach is an effective countermeasure to the cognitive bias inherent to humans. New investors and experienced ones 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. Regular, automated investments prevent spontaneous, illogical behavior. The same Vanguard study even concluded, “If the investor is primarily concerned with minimizing downside risk and potential feelings of regret (resulting from lump-sum investing immediately before a market downturn), then DCA may be of use.”
Once You’ve Identified Your Strategy
So you’ve narrowed down a strategy — great! But 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 will need to cover your investments. That includes how much you can deposit at first as well as how much you can continue to invest going forward.
You’ll then 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 a robo-advisor. This will help you figure out the cost of investing from management fees to commissions you’ll need to pay your broker or advisor. Another thing to keep in mind: Don’t turn away employer-sponsored 401ks — that’s a great way to start investing. Most companies will allow you to invest part of your paycheck and tuck it away tax-free and many will match your contributions. You won’t even notice because you don’t have to do a thing.
Consider your investment vehicles. Remember that it doesn’t help to keep your eggs in one basket, so make sure you spread your money around to different investment vehicles by diversifying — stocks, bonds, mutual funds, ETFs. 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.
Finally, investing is a roller coaster, so keep your emotions at bay. It may seem amazing when your investments are making money, but when they take a loss, it may be difficult to handle. That’s why it’s important to take a step back, take your emotions out of the equation and review your investments with your advisor on a regular basis to make sure they’re on track.
The Bottom Line
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. Ignoring these aspects can lead to a high abandon rate and frequently changed strategies. And, as discussed above, numerous changes generate costs that eat away at your annual rate of return.
This article by Ben Taylor was previously published on Investopedia.com
About the Author:
- 10+ years experience as a financial journalist and Wall Street analyst
- Currently working as a Marketing Content Manager at Richardson, a global sales training company
- Author of The 90 Minute Personal Finance Plan for Life
Ben Taylor has been a financial journalist and financial analyst for over a decade. He has written eBooks, white pages, blog postings and articles for a variety of companies.Ben has written most recently for Nasdaq, Business Insider, Yahoo Finance, Seeking Alpha, Motley Fool and others. His Kindle eBook The 90 Minute Personal Finance Plan for Life published in 2016, was an Amazon Personal Finance section best-seller.
Ben’s expertise includes investment strategies, trading, retirement, socio-economic trends, cryptocurrency and portfolio balancing. He was a Financial Adjustment Associate at Vanguard between 2004-2005 and a Senior Operations Representative at StockTrans/Broadridge between 2005-2006, before seguing into financial writing. Ben currently works as a Writer and Researcher at Financial Content Management and as a Marketing Content Manager at Richardson, both located in the Philadelphia area.
Ben earned an MBA in Finance from LaSalle University, and a BA in english literature from Denison University.
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