In 2020, many new private investors entered the US markets. Bloomberg Intelligence estimated the share of individual investors in the US equity trading volume at 19.5%. This number has doubled compared to 2010, proving that financial literacy has become a trend of the passing decade.
Such an influx of individual investors is great for stabilizing the market conditions. New people bring in more money, increasing the liquidity of assets. It means that securities can be bought and sold faster and with less variation between prices. Overall, more investors means more buyers, so larger trades won’t have a strong impact on the market.
On the other hand, the arrival of new investors entails some problems, although they are not global and mostly involve investors’ personal success. In some cases, beginners do not earn anything and only suffer losses both due to market fluctuations and insufficient experience with financial instruments.
The most common reason behind failure is the lack of investment strategy. Each novice investor should choose assets carefully before placing their funds.
What is an investment strategy?
An investment strategy is an approach to buying and selling securities depending on the goals and personal characteristics of the investor. Without it, investments often turn into blind gambling. A strategy determines investor’s behavior on the stock exchange. It is usually based on the following parameters:
- type of assets chosen for investments,
- frequency of transactions,
- reasons behind decision-making (i.e. news that affects the market).
To form the simplest strategy, an investor is to determine the desirable assets, the investment period, and the maximum loss limit.
Factors of good portfolio performance
But why do some investors earn more than others? What determines the profitability of an investment? The answer has been known since 1986, when Gary Brinson presented “Determinants of Portfolio Performance”, where the results of investing in American pension funds were studied.
Gary Brinson assumed that the portfolio profitability was affected by lots of factors. But as it turned out, there was only one decisive factor. The success of investments was determined by:
- 93.6% — distribution of assets by class (stocks, bonds, or cash)
- 4% — choice of specific securities
- 2% — the timing of purchasing or selling securities
- 1% — commissions
The results of the study showed that diversification was the most important part of building a strong portfolio. No certain assets guarantee great returns, which means that investment strategies are pretty universal. However, before diving into actual step-by-step instructions, let’s see how strategies are divided by classes.
Points to consider before selecting a strategy
Investing styles depend on the person’s character and financial situation. Apart from that, they are mostly affected by age. Younger investors have time to recover lost capital, so they can invest in riskier assets. Older investors are more focused on capital preservation and stable income.
To choose a strategy, one needs to determine their investment preferences.
- Goals. This can be retirement savings, an alternative to a bank deposit, active speculation, gaining experience, etc.
- Time period. It’s advisable to designate how long certain assets will be owned. This way, market fluctuations won’t affect investor’s mental health too strongly.
- Risk level. How much money is an investor prepared to lose? Which risk level would cause strong anxiety?
- Extent of market research. Some investment strategies require constantly monitoring the market, news, studying company reports, and selecting shares.
Classification of investment strategies
Each investor has their personal investment strategy. Nevertheless, all methods have common features and therefore can be categorized into several types.
By investment term
There are long-term, medium-term, and short-term investments.
- Long-term strategies have no clear end of investment period, so long-term assets are purchased for more than 7–10 years. Typically, longer terms are considered conservative since they don’t require many transactions. Hence, such strategies are most suitable for investors who do not want to constantly monitor the market.
- Medium-term strategies imply a stricter time limit, for example, 3–5 years. With this strategy, investors often choose stocks of companies that have consistently paid high dividends over the past few years, and sell them when dividends begin to decline.
- Short-term strategies are close to active speculation. For example, investors would buy shares in an IPO with the goal of selling them in a few days or months.
There are active and passive investment strategies.
- An active strategy means paying close attention to market conditions. For example, in short-term strategies, asset purchase or sale might be a reaction to some global news. In long-term strategies, active transactions are made after a thorough research of company reports based on which securities have higher/lower potential.
- A passive strategy implies endurance and a small number of transactions, so it does not require investors’ participation. A long-term buy-and-hold strategy is a clear example of a passive approach. Passive investments are suitable for those who are comfortable with longer periods between investing and making a profit.
Individual investors are more likely to choose active investment strategies. However, both approaches can be combined into a single, more flexible framework. It suggests buying assets that generate income in the form of coupon payments on bonds or dividends on shares. Apart from fixed-income assets, an investor would also invest in growth, i.e. purchase securities that are already growing in value.
By degree of risk
There are high-risk, moderate, and low-risk strategies. The higher the risk, the higher the income, but the losses would also be significant.
- High-risk strategies use assets with potentially high returns, for example, stocks of startups and smaller companies. They can either fly high or burn out, providing a high yield with an equally great chance of failure.
- With a low-risk strategy, investors choose the most reliable instruments in the stock market, i.e. government bonds or debt securities of the most successful companies.
- The most common are investments with moderate risk. It is achieved through diversification. For example, a moderate-risk portfolio consists of bonds, liquid stocks, currencies, and shares of growing companies.
The risk depends on the investment purpose and whether it is affordable for an investor to lose money. To save for retirement, you would want to follow conservative, low-risk strategies. And vice versa — to have extra income, you can buy shares in an IPO, but be prepared to risk money.
The most known investment strategies
Strategies can be applied as a whole, combined, or partially if an investor only likes some of their elements. Below, you will find the most common investment strategies across all the categories.
Investing in growing market value
Most often, investors choose stocks based on high growth rates of profits or sales. A company can be appealing if it grows faster than the industry as a whole, but at the same time, its growth rate is not enormous. Typically, small-cap stocks rise faster than large-cap stocks.
At certain points, entire industries might be growing — for example, manufacturers of vaccines during the corona pandemic. Analysts often come up with lists of promising industries, trying to predict which ones could develop the most.
Growth stocks can be selected via screeners like Zacks.com, Yahoo Finance, etc. To do this, you can filter for an industry of your interest, set EPS growth for the current year above the industry average, and financial ratios below the industry average.
Investing in undervalued companies
In this strategy, investors buy undervalued stocks based on various indicators. Undervalued company’s shares are worth less than its actual assets.
It might happen for a lot of reasons — for example, because companies’ reports are below expectations, or the growth rates are slow, or the industry is irrelevant at the moment. When prices of undervalued companies rise, investors would sell them, thus gaining profit.
To find undervalued companies, compare their growth to the S&P 500 (more on that below) or to average industry ratios. Set the P/S, P/B, P/E, and Debt/Equity multipliers in the screener to be less than the index average.
Investing in a stable income
Stable income is brought by dividend stocks or bonds. This investment style used to be popular, but not anymore as current tech companies don’t pay dividends.
One of the most famous dividend strategies is called Dogs of the Dow. Each year, investors choose from the Dow Jones Industrial Average index 10 stocks with the highest dividend yield. The portfolio must be rebalanced every year. This strategy even has its own official website.
If profits grow faster than the industry or the market as a whole, the company will be able to pay dividends without compromise. Using Dogs of the Dow as a filter will remove companies that pay dividends at the expense of their own development.
Morningstar Style Box
The matrix created by Morningstar has 9 squares. It’s a method of systematic presentation of investors’ portfolios.
The vertical axis is for capitalization. The horizontal axis is for the fundamental characteristics of value and growth. Stocks or shares of mutual funds are placed on each square depending on their KPIs. The central square belongs to securities that are equally dominated by growth and value.
An “all-weather” portfolio is a concept of a “lazy” set of investments that would be resistant to any economic distress. The idea was developed by Ray Dalio.
The portfolio contains different types of assets that behave differently during periods of high or low inflation, economic boom, and economic recession. Unfortunately, such a portfolio cannot provide crazy returns, but the risks are minimal.
An investment portfolio can be based on acceptable risk. To adjust to an acceptable level of risk, an investor needs to change the ratio of their assets.
For example, an investor is ready to lose no more than 20% of their initial capital. Because of that, they would start buying assets based on this criteria and think of potential profitability afterwards.
Investing randomly is a strategy in the same way as not choosing anything is a choice. In this approach, the investor selects companies randomly — for example, after reading some Twitter experts or hearing from their friends.
Sometimes an investor would buy stocks or shares out of fear of missing out. For example, after corona-growth of Moderna shares, even those who never made investments wanted to purchase them.
Random investing isn’t always a bad thing, there can be generally nice investment tips out there. But if an investor has no plan, they might sell securities too soon or fail to fix their losses. Overall, not understanding the company whose shares you buy may result in not getting the result you want.
Testing the chosen investment strategy
Testing the chosen strategy is vital for understanding how profitable this portfolio has shown to be. During tests, the returns of the chosen securities are compared to the S&P 500 index. The S&P 500 index covers approximately 80% of the US market capitalization and gives an idea of the main trends.
Sure, past performance does not guarantee future. However, by comparing the portfolios’ performances investors can see whether this strategy was worth following as of today. If a strategy has been unprofitable for several years, investors should think very carefully before applying it to their portfolio. After all, the chance that a previously unsuccessful set of securities would skyrocket is close to none (although not impossible).
Testing on historical data before making investments is called backtesting. Backtesting helps you see what strategies worked and/or didn’t work. No trading strategy has been 100% profitable. Most often, profitable instruments go up to 60–70%, unprofitable 30–40%.
You can test your strategy on the free Portfolio Visualizer website.
To maintain their capital in the stock market, an investor needs a strategy. An investment strategy is an investor’s personal plan to build a portfolio and manage it.
Strategies differ from each other in terms of investment period, risk levels, and activity. The investor can combine several ideas and come up with their own ways to increase profitability.