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Investment strategies 101: The full breakdown

At a glance:

  • Investing for growth

  • What is value investing?

  • Market timing 101

  • Market timing vs Buy and hold

  • How to invest for income

  • What are formula investment plans?

  • Summary of investment strategies 101

  • Practical ideas you can start with today

Different investors swear by different investment strategies. Some even become synonymous with them (think Warren Buffett with long-term, buy-and-hold investing, and Benjamin Graham with value investing). And many investors like to combine more than one approach into a larger strategy. For example, value investing, growth investing, and buy-and-hold investing tend to work well when used together.

The strategy you settle on will be a reflection of what you want money to do for you and how much market uncertainty you can stomach.

Investing for growth

Investing for long-term growth is one goal to consider when investing your money. Growth comes from an investment's price appreciation over time. Growth-oriented investments pay little, if any, income, but the increase in their value can outpace inflation. Why would someone want to invest for growth?

Reasons for investing for growth

  • To save for retirement

  • To save for college education

  • To buy a house

  • To provide long-term care for his or her parents

These goals are long-term in nature. Types of investments that are traditionally well suited for long-term growth include the following:

Growth investments

  • Common stocks, including those of smaller and newer companies

  • Growth mutual funds. Understand the risks of growth mutual funds. [Popup text: Investing in mutual funds involves risk, including possible loss of principal. Investments in growth funds have additional risks, which are outlined in the prospectus.]

  • Real estate

  • Collectibles

Things to remember about growth investments

Because of the higher volatility of growth investments, there is potential for a higher reward for those who take that risk. This volatility and potential loss of principal needs to be considered prior to investing. However, to overcome the possibility of short-term losses, you might have to hold these investments for a longer period of time, and you only realize your profits when you sell them. You will need to balance your growth goals against your need to be able to liquidate your investment—that is, to turn it into cash without a loss.

Learn more about the risks involved with stocks and mutual funds. [Popup text: 1. Stocks are not appropriate for all investors or strategies. Ensure that your investment objectives, time horizon, and risk tolerance are aligned with risks of stocks before investing, as they can lose value. 2. Mutual funds are sold by prospectus only. Investors should consider the investment objectives, risks, charges, and expenses carefully before investing. The prospectus contains this and other important information and should be read carefully before investing.

What is value investing?

Value investing means investing in stocks that are currently trading for less than their book, or intrinsic, values. (The term can be applied to any other investment that sells in the market for less than its book value.)

Value investors use strategies

In general, they seek reasons that a stock's potential may have been overlooked and that its actual trading price may soon increase.

For instance, a stock may be undervalued because its short-term outlooks are poor. Maybe it is in a depressed industry, or perhaps sudden growth in a new market has temporarily decreased earnings. Management may be overly conservative and may not promote the company as much as it deserves. A variety of reasons may contribute to the stock's undervaluation. If these problems appear temporary, a value investor may decide that the stock is undervalued. But is now the best time to purchase this stock? What is the likelihood that the stock price will increase in the near future?

Value investors aim to identify variables that may soon push up the price of a stock: new management, a revised stock analysis by Wall Street, or a corporate takeover, for example. These variables may relate to the internal operation of the company, such as new management or a new product introduction. Or, they may be external variables, such as a revised stock analysis, falling interest rates, or an upturn in the industry.

What to look for in value investing: P/B and P/E ratios

Many factors can help investors identify strong companies with stock that is temporarily undervalued. A starting point may be to look at the price-to-book ratio (P/B) and the price-to-earnings ratio (P/E). The price-to-book ratio is the stock price divided by the book value (the value of the company's assets). If a stock's price is $20 and its book value is $30, the price-to-book ratio is 2/3. A stock with a price-to-book ratio of 2/3 or less may indicate a value stock. Similarly, the price-to-earnings ratio is the stock price divided by the company's annual earnings. A stock with a price-to-earnings ratio of 2/3 or less that of other companies in its respective industry or the market as a whole may also be a value stock.

Return on equity

Another important factor to review is the company's return on equity (ROE). The ROE is a percentage calculated by dividing the net income of a period by the common stock equity, or net worth. When it comes to value investing, a declining ROE can be a good thing, since it may suggest that the company is financing with less debt and holding more assets, which could be used for acquisitions or other growth. Of course, further investigation would be necessary to confirm those reasons.

Value investors also may examine a company's dividend yield, or the investor's annual percentage of return per share, as well as its debt load, cash flow, assets, and earnings history. Identifying these figures can help investors evaluate whether the company has the resources and expertise needed to grow profits and deliver earnings in the future.

Market timing 101

Market timing has long been viewed as a way to "beat the market" because it selects the best time to be in it and when to be out. There is much controversy over the results. The goal of market timing is to avoid major drops in market prices and enhance an investment account's value.

Market timing attempts to gain higher returns than other investments with similar risks. It examines the directions of the markets and the forces affecting market changes.

Timing the market

Market timers look at indicators to determine when to buy or sell their shares. Indicators are data points determined by mathematical formulas. When an indicator points to a good time to buy a stock, it is called a buy signal. When an indicator points to a good time to sell a stock, it is called a sell signal.

Indicators used: market averages and moving averages

There are many types of indicators used by market timers. To look at the changes in a market over time, a market average is used. A moving average is an average of data (e.g., closing prices) covering a period of time (e.g., 90 days) going back from the date of calculation and periodically (e.g., weekly) recalculated. (Other time periods may be selected for the calculations.) When a price moves above or below a certain market average, the investor knows when to buy or sell.

Indicators used: market volume

Market volume indicators look to see whether stocks gaining or dropping in price are getting the biggest share of market activity (volume). Volume is the total number of traded shares. Periods of low volume indicate investor indecision. High volumes usually indicate new trends and higher share prices.

Indicators used: investor feelings

Market timers also look at investor sentiment. The more investors are optimistic and ready to buy, the more the market is likely to fall and vice versa.

Indicators used: resistance level and support level

When looking at a stock's price history chart, you will notice that after the price of a stock reaches a certain level, it usually goes down (the resistance level), and when it reaches a certain floor (its support level), it will climb back up. An investor who uses market timing will try to buy as close to the support level as possible and sell near the stock's resistance level.

When buy and sell indicators occur near each other, the phenomenon is called a whipsaw. A whipsaw indicates that investors are reversing themselves. This can make it difficult for investors to time their trades accurately, with potentially costly results.

Market timing vs Buy and hold

Market timers actively buy and sell securities because they believe certain securities or markets are overvalued or undervalued. There are several potential advantages to market timing.

First, it provides the structure for an investment strategy and can reduce risk in a given asset class. Second, it can protect investments in down markets by pulling funds out of the market and placing them in risk-free, interest-bearing accounts.

Consider the cons

But there are several drawbacks to market timing as well. Timing methods that do not work as intended can be costly. Furthermore, the best strategies underperform the market. Market timing can be appropriate for reducing volatility, but it does little for outperforming the market.

There is an alternative to market timing

The alternative to market timing is the buy and hold strategy. When you buy and hold, you select a balance of assets for your portfolio, buy them, and then hold onto them for the long term. You do not actively change your asset allocation. This is not to say, however, that you do not regularly rebalance your portfolio to maintain a certain mix of investments. As soon as you start selling to cut your losses, you are using market timing, which may result in selling under-performing investments or purchasing investments that are undervalued.

Why buy and hold?

The advantages to buy and hold are the ease of managing your portfolio and the greater tax efficiency. Disadvantages include the possibility of substantial losses over the short term, and possibly over the intermediate term, as the result of higher portfolio volatility. However, buy and hold investors hope that if they hold their volatile investments long enough, long-term growth trends will overcome any short-term market losses; and in the stock market, at least, time has proven them right.

So will it be market timing or buy and hold for you? The answer may depend on the length of your investment time horizon, and whether you can invest the time and know-how to successfully time the market—or pay someone else to do it for you.

How to invest for income

One of the goals you might have for investing is to generate more income. What kind of investor might have this as his or her goal?

Who invests for income?

  • Someone who is retired

  • Someone who wants financial security and independence

  • Someone who wants a comfortable standard of living

  • Someone who wants to pay off debts and bills

  • Someone who wants extra money to travel

Certain types of investments can be more effective than others for generating income on a regular basis. These include the following:

Common income investments

  • Cash and equivalents, including money market accounts, CDs, and Treasury bills and notes. These instruments provide interest income on a regular basis. Learn more about the risks of money market accounts and Treasury bills.

  • Bonds, including Treasury, municipal, and corporate bonds. These provide a higher level of fixed income over time. Learn more about the risks of fixed-income investments.

  • Income stocks, including preferred stock, utility stock, and high-capitalization blue chip stocks. These stocks pay income in the form of dividends. These dividends should not be considered guaranteed, as companies often decide to lower or not pay them in certain circumstances.

  • Income mutual funds. Income funds provide a way of investing in diversified portfolios of income investments such as the ones mentioned above, and may provide reliable income over time. Learn about the risks of mutual funds. [Popup text: Mutual funds are sold by prospectus only. Investors should consider the investment objectives, risks, charges, and expenses carefully before investing. The prospectus contains this and other important information and should be read carefully before investing. Income funds may carry additional risks and fees.]

However, a portfolio made of these investments may run the risk of not growing as much in value over time as would a growth-oriented portfolio. Some investors find that they need to balance their goal of income with their desire to build the value of their investment capital. Even though typically less volatile than growth investments, income-related investments have unique risks that need to be considered before investing including interest rate risk, credit risk, duration risk, and prepayment risk.

What are formula investment plans?

Speculating in the market is not always limited to those who have a lot of money. With some skillful manipulation of your portfolio, you can use formula plans to help you speculate with small amounts of money.

There are a number of formula investment plans that can help you do this. Two such plans are the constant-dollar plan and the constant-ratio plan.

Two parts to a plan

Often, formula plans divide an investor's portfolio into two portions: speculative and conservative. The speculative portion contains aggressive, volatile securities with the potential to earn large returns or create significant losses. The conservative portion holds less-volatile securities—such as government bonds—that are expected to grow slowly but steadily.

What investors should do

Formula investors carefully monitor the speculative portions of their portfolios. As this component changes in value, investors add to, or reduce, their positions to maintain a pre-determined level of ownership of speculative securities. This level of ownership is simply measured in dollars in a constant-dollar plan. In contrast to that, a constant-ratio plan maintains a set percentage of the overall portfolio value in speculative securities.

What are constant-dollar plans?

In a constant-dollar plan, the investor divides his or her investment portfolio as described above, then establishes a specific dollar amount for the portfolio's speculative portion that he has established, and puts the rest of the funds into the more conservative portion. The investor then sets "trigger points" slightly above and below the constant-dollar amount. When market movements cause the dollar value of the speculative portion of the portfolio to rise or fall past a trigger point, the portfolio is rebalanced, so the dollar amount invested in the speculative assets remains constant.

An example

Let's say an investor wishes to maintain $1,000 of his portfolio in a speculative high-tech stock. If the price of the stock is $10 a share, that's 100 shares of the stock. If the price rises to $20 a share, the investor will own $2,000 of stock. To maintain his constant-dollar plan, the investor will sell 50 shares ($1,000) and reinvest the gains in more conservative investments, such as Treasury bonds.

Conversely, if the value of the high-tech stock falls below the desired trigger point, the investor will sell some of the conservative investments and buy more shares of the tech stock.

What are constant-ratio plans?

In a constant-ratio plan, the investor divides his or her investment portfolio as described above, then establishes a constant ratio between the speculative and conservative portions of the portfolio. When the ratio between the two sides differs very much from the desired ratio, the investor rebalances his or her portfolio.

When the speculative part of the portfolio falls below the set ratio, funds are added to it from the conservative portion. When the speculative securities rise in value, some are sold and the proceeds are reallocated to increase the value of the conservative portion.

An example

Suppose an investor wishes to keep 10 percent of his $10,000 portfolio in stock XYZ. That means he has $1,000 of it. But what happens if the value of the whole portfolio rises to $20,000? The investor now adjusts his shares of stock XYZ to a value of $2,000 worth, or 10 percent of $20,000.

Formula investment plans are a way to help investors monitor and guide their speculation with systematic strategies that can reduce risk and maintain steadier returns. Before you can effectively use one of these plans, you must choose an amount or percentage of your portfolio to devote to speculation. This is an important decision, not to be made lightly.

Summary of investment strategies 101

See a strategy you like? See several that you like?

Most investors can intuitively grasp the validity of each style of investing. The question is, which one or which ones to use? These will take some thinking on your part. A big thing to settle in your mind is just how much tolerance you have for risk, because many strategies will expose you to a lot of it. Can you afford the possibility of loss? Do you have enough years ahead of you to regain any losses you suffer? Do you have some other way to regain any investment losses? Can you live without money that is tied up long-term in some chosen investment?

Once you are sure how much risk you can stomach, you can start working on your own strategy.

Practical ideas you can start with today

  • Identify your investment goals.

  • Determine your risk tolerance.

  • Create a diversified portfolio of investments that is likely to provide the greatest return in keeping with my risk tolerance.

  • Assess my ability to recoup losses from investments that do not perform well.

This content was created in partnership with the Financial Fitness Group, a leading e-learning provider of FINRA compliant financial wellness solutions that help improve financial literacy.

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