One person wants to save for retirement 25 years. Another wants to invest in various instruments for no longer than a year. These investors have different goals and investment timing, which means different market behavior. To avoid placing in rash positions, everyone needs an investment strategy. In this article, we will consider what that is and learn popular types of investment strategies.
What Is An Investment Strategy
An investment strategy is a plan by which an investor buys and sells stocks. It includes the purpose of the investment, its time horizon, the choice of assets, and the rules for buying or selling them.
It is a detailed plan of action that helps:
- To avoid making impulsive actions and placing reckless trades;
- Understand how to act when markets are falling or rising;
- Choose which assets to buy and which to sell;
- Predict approximate returns based on historical quotes;
- Make your own decisions consciously, rather than copying the trades of other investors or recommendations from dubious communities on social media.
Following a strategy reduces the risk of loss and allows investors to manage their portfolios rationally.
Types Of Investment Strategies
Every investor has a different investment strategy, but they are basically divided into several types. According to the term of investment: long-term, medium-term, and short-term. In the stock market, it is impossible to say exactly which period is considered long-term and which is medium-term. Long-term strategies are those where there is no clear end to the time of investment, or the investment horizon is distant - more than 7-10 years.
Generally, the longer an investor plans to hold stocks and the more conservative their goal is, the fewer positions they open. Therefore, long-term strategies are suitable for investors who do not want to constantly monitor the market.
The best known long-term strategy is "buy & hold": Buy different assets, but do not sell them, even if the price goes down. The idea is that historically in the long run markets always go up.
- Medium-term strategies involve time constraints. For example, a five-year bond portfolio. Also, investors with this strategy often choose stocks in companies that have been consistently paying high dividends for the past few years and sell them when dividends start to decline.
- Short-term strategies are similar to active speculation. For example, buying stocks at the IPO in order to sell them in the days or months after the start of trading.
In terms of activity: active and passive. An active strategy implies constant attention to what is happening in the market. For example, short-term strategies may be reacting to the news, while long-term strategies may be studying company reports and frequently rebalancing your portfolio: buying new stocks and selling those with low potential. A passive strategy does not require active investor participation and involves exposure and a small number of trades. For example, the long-term strategy is "buy & hold".
According to the degree of risk: high risk, moderate risk, low risk. The higher the risk, the higher the income, but losses can also be substantial. High-risk strategies use instruments with potentially high profitability. For example, second- and third-tier stocks, which can either skyrocket or go bust, or high-yield yet high-risk bonds.
Using a low-risk strategy, investors choose the most reliable instruments on the stock market: government bonds or debt securities of systemically important companies. The most common option is moderate-risk investments. It is achieved through diversification, i.e., a variety of instruments and industries. For example, one part of the portfolio is bonds, another part is liquid stocks, the third part is second-tier stocks from various industries, and the fourth part is currency. The choice of risk depends on the purpose of investment and readiness to lose money. For instance, one investor wants to save for retirement. A conservative, low-risk strategy may be appropriate (for example, a portfolio of government bonds). Another wants additional income and is willing to risk the money, so they choose to buy stocks upon an IPO.
Most Popular Investment Strategies
A strategy can combine several ideas at once. And if there are several goals, the actions for each portfolio can be different. In general, there are several methods of investing that investors around the world use.
This strategy is also called stable income investing: an investor buys shares of companies that pay dividends. Over the past few years, there are fewer of them: in 2009, 43% of companies around the world cut, and 14% completely canceled dividends. The new round of declines in dividends paid came in 2020 when the pandemic caused businesses to struggle. Traditionally, tech giants and fast-growing startups do not pay them - they put the free money into development.
It's not all bad: many other companies pay dividends on schedule and even increase their size annually. In the US, they are easily tracked by the Dow Jones index, which covers the top 30 businesses. You can also rely on the total returns of individual markets, as Vanguard analysts advise.
Dividend investing is for those who are risk-averse and have a large enough amount to buy a block of shares. In this case, the investor will receive a tangible income on an ongoing basis.
Other names for this investment strategy plan are investing in undervalued companies. Famous billionaire investors Warren Buffett and Benjamin Graham use this plan. The essence of the strategy is to find and buy stocks, which sell at a price below their real market value - that is, in fact, they can be called undervalued.
To develop an investment strategy and implement it, you need not only a good eye and intuition - you will have to study the basics of fundamental analysis, and understand ratios, balance sheets, and other financial indicators.
Understanding financial market processes will help you see the reasons why stocks are cheaper than their fair price. Usually, the company that issued them is very slow to grow, its products are not in demand, or the entire industry is stagnant.
If you choose to pursue this strategy, focus on key ratios:
- Price (P/E - price/earnings and P/B - price/book value);
- Profit analysis (revenue, gross profit);
- Profitability (gross, operating, net);
- Capital structure;
The ratios can be looked at over the past few years or assessed by comparing companies within the same industry, for example. Many investors use the Graham Ratio to find undervalued stocks. The strategy is suitable for the most patient, risk-averse investors who know how to wait, have time, and do not expect quick results.
Investing In Startups
A risky strategy that can work out of the blue and bring super profits. The idea is to find a relatively new company whose growth rate can soon outpace the market average. Peter Lynch, an American investor and author of "Beating the Street" became famous and rich through observation and meticulousness. He looked for young, little-known companies with potential and paid attention to the smallest signs of their future success. If he found out that a company had recently launched a quality product that was just beginning to be talked about in small circles, he sought to buy that company's stock before it rose in value.
This strategy is suitable for observant investors with good intuition and plenty of time.
Proponents of this strategy sell and buy stocks, making money on value jumps during the day. Some investors use special software for this purpose, while others do everything manually. With this strategy, you can make daily income and lose money, too. For constant selling and buying, choose at least five and no more than ten stocks of different companies. These should be liquid securities that are easy to sell. For example, second-tier stocks - easily go up and down. They have good investment potential, but they are less stable than first-tier stocks, which are highly liquid and provide a stable income.
It will be perfect for young and active investors who are willing to take daily risks. The strategy is best not used by novice investors who are not aware of the level of risk of buying and selling stocks.
Investment strategies can be combined. For example, proponents of a hybrid strategy often buy stock in a company that pays dividends and grows at the same time. These are solid businesses with high capitalization, which still have horizons for moderate growth - they are also called "blue chips". At first glance, the strategy looks rational and capable of bringing a stable income to the investor. However, large companies grow very slowly and may refuse to pay dividends at any time.
It will be suitable for those who are willing to spend time looking for companies with good fundamentals and growth potential. You have to be prepared for the fact that the company will suspend payments to shareholders at any time.
One should keep in mind that random buying and selling of stocks is not a strategy, because in this case, it is impossible to predict even approximate profitability and to obtain a stable result. In order not to get lost in the stock market and get a return on investment, it is best to stick to a clear plan.
How To Choose An Investment Strategy
You can use the strategies as a whole, combine them or take the elements you like. The main thing is to be satisfied with the yield and remain comfortable for the investor: the higher the yield, the higher the risks and the probability of stress.
To choose a strategy, you need to determine your preferences:
- The purpose of investment. All further steps depend on the goal. This can be saving for retirement, an alternative to a bank deposit, or, for example, active speculation and gaining experience.
- The time of investment. Indicating the time interval is important for the choice of instruments and psychological calm, so the fluctuations in the market will not cause strong emotions.
- Risk level. How much the investor is ready to lose and under what circumstances they will refuse to place new positions. Which risk is comfortable, and which will cause internal excitement.
- Time to study the market. Whether the investor is ready to follow the market and news, study company reports and select stocks in a portfolio.
For example, an investor wants to invest money in the stock market for five years and be able to earn more than he could on a bank deposit. They are ready for moderate risk and can devote several hours a week to news and studying companies' reports. So, medium-term strategies with moderate risk are suitable for them.
The choice of strategy is one of the most difficult and important stages at the beginning of the investment. The strategy helps not to get confused in difficult situations and not to lose money on random transactions. Not having a clear plan of action can be the biggest mistake a novice investor makes. But also choosing the wrong strategy can deprive him of a considerable part of the capital. The sparer cash an investor has, the easier it is to diversify their investment portfolio and protect themselves from risks caused by unforeseen market fluctuations.