Read this article to understand some key strategies that you can use before you start investing. We will help you determine which one is for you (or which combination) by explaining each approach and outlining its pros and cons…
Value Investing
Value investing is an investment strategy that involves buying stocks that are undervalued compared to the broad market or industry.
Analysts do this by determining the intrinsic or fair value of a stock which is basically the price they believe a stock should be trading at. If that price is higher than the current one, they deem the stock undervalued and worthy of buying.
To determine the intrinsic value of a stock, a value investor will use some metrics that make use of financial results. Here are a few that are commonly used:
P/E Ratio - The Price to Earnings ratio (P/E) or earnings multiple is basically a measurement of how many times over the earnings of a company the market is willing to pay for its stock. It indicates that by dividing the price of a stock by the earnings of its underlying business.
P/B Ratio - The Price to Book (P/B) ratio measures how many times over the book value (net worth) of a company the market is willing to pay for its stock. It’s calculated by dividing the price of the stock by the underlying company’s book value (equity/net worth per share).
P/S Ratio - The Price to Sales (P/S) ratio measures how many times the market is willing to pay for a stock over the underlying business’s revenue. You can calculate it by dividing the current price of a stock by the latest annual revenue reported.
Let us now examine a few pros and cons of this strategy…
Pros:
- Low Risk - Value investing is known as a conservative investment approach that prioritizes preserving your capital over returns.
- Long-Term Returns - Value stocks can grow for years after you bought them.
Cons:
- Hard to Implement - Value investing is a buy-and-hold strategy that requires a long-term mindset and a lot of patience, things that most investors lack.
- Valuation Mistakes are Common - It’s common for value investors to deem a stock undervalued while it is actually fairly valued and isn’t about to grow in the future; this can occupy a portion of your fund that doesn’t offer you any returns for years.
Who Is It for?
Value investing is for those who can be confident in their belief that they are right when they buy/sell a stock and the seller/buyer is wrong. They also need to preserve that confidence for years as the market might be slow to recognize a stock’s value
At the same time, value investing is the perfect approach for the risk-averse, as buying below fair value offers a cushion against market downturns.
Growth Investing
Growth investing is an approach that focuses on stocks that are perceived as capable of outperforming the broader market.
Besides examining the past performance of a business, growth investors also examine the industry to gauge the growth prospects. But they almost always want to see some good recent operational results of the business before anything else.
Here are a couple of metrics that they use to interpret financial results:
Return On Assets (ROA) - This metric examines how much the assets of a business contributed to the production of its earnings. It does that by dividing the net income by the total assets of a company.
Return On Equity (ROE) - The ROE shows the earnings that were generated from the shareholder’s point of view by dividing the net income by the equity; this is basically the net worth of the company or what shareholders have a claim on in case of bankruptcy.
Net Margin - Net or profit margin is simply the portion of a company’s revenue that ended up as net income after accounting for all expenses, expressed as a percentage. This allows analysts to identify a company’s efficiency to keep costs low.
Pros/Cons:
Growth stocks can potentially reward you with great returns if you know how to look for those that are about to be greatly appreciated by the market.
But the trade-off here is high risk as growth stocks are rarely undervalued if they have a long history of outstanding growth.
Who Is It for?
Growth investing is for those who have a high-risk tolerance and aspire to beat the market by a great margin.
Momentum Investing
Momentum investing aims to take advantage of positive market sentiment by buying a stock based on recent upward price momentum. In other words, a momentum investor will try to “ride the wave” of a rapid price increase.
Momentum investing also involves selling a stock as soon as that wave is near its end based on indicators that its price is going to fall.
Momentum investing mainly uses technical analysis to gauge the momentum of a stock’s price. Link to guide
Pros/Cons:
Since this approach is more active than others, it relies on the prospect of great returns over a short period to achieve long-term success. If it’s applied by an experienced investor, it can be a very lucrative strategy
At the same time, if you are wrong in your analysis, you may lose a lot of money and fast. Another disadvantage is that because you are very active, you incur high transaction fees and tax expenses.
Who Is It for?
Momentum investing is mainly for those who want to achieve short-term gains. But you will most benefit from this approach if you have the time and discipline to learn technical analysis.
Dividend Investing
Dividend investing attempts to create a passive income stream through the collection of dividends.
A dividend is a portion of the earnings that a company chooses to distribute to its shareholders. Most stocks that do pay dividends do so every quarter, while some pay them on a monthly basis.
Here are a couple of metrics that dividend investors look at before they buy a dividend stock:
Payout Ratio - This is the portion of a company’s net income that is used to pay dividends, expressed as a percentage. For instance, a 50% payout means that a company distributes half of its net income as a dividend to its shareholders.
Dividend Yield - This is simply the annualized dividend paid per share divided by the share price. Dividend investors use it to gauge the annual return on their invested capital they can expect from a dividend stock.
Debt to Equity Ratio - This metric measures the financing structure of a company by dividing its debt by its equity. If this ratio is high, it means that a company has too much debt and may have to stop paying its dividend if it runs into trouble down the road.
Pros/Cons:
The greatest advantage of dividend investing is it yields stable returns. As opposed to returns realized through price increases, dividend investing has the benefit of recurring income that is more predictable than capital gains.
On the other hand, a vital drawback here is that your returns through dividends are taxed. If you’re looking to reinvest the dividends anyway, it makes sense to look for growth stocks instead.
Who Is It for?
Dividend investing is for those who have a large fund and are looking for passive income. It’s also ideal for retirees or those who want to have more stable and predictable returns than other strategies provide. Many people taking advantage of this strategy tend to invest in so-called dividend aristocrats.
Cyclical Investing
Cyclical investing focuses on businesses that are cyclical, meaning that they follow the macroeconomic cycle (expansion, peak, recession, and recovery). Prices of cyclical stocks go through these stages too.
So, the cyclical investor will attempt to buy a stock during recovery and sell during its peak. That is, of course, easier said than done as you must have a very good understanding of how correlated an industry is to the economy.
The financials that cyclical investors examine are similar to those other types of investors also analyze. But you also need to see how close the fundamentals of a business move to those of the industry to time your transactions correctly.
Pros/Cons:
The primary advantage of cyclical investing is that it offers the chance to make great returns in a very short time. A natural disadvantage is that this is risky as it’s challenging to get right. A very good understanding of both a business and its industry is crucial here.
Who Is It for?
Cyclical investing is for those who are looking to achieve satisfying returns and be liquid at the same time. Since you don’t hold cyclical stocks for the long term, your cash moves in and out of positions all the time.
Conclusion
Now you know what your options are. Equipped with all the implications of the main investment strategies, you’re more likely to select the one that best fits your goals and temperament.
But before you start investing, make sure that you pick the right broker. Choosing the right platform is also crucial for meeting your investment goals, whatever they are.
And that’s why we created a free tool that will recommend those brokers that are most likely to help you in your investment journey. Spend a minute to set the foundation for long-term success by using our comparison tool today!
