There are many different trading approaches available to investors. The selection of the trading approaches should take into account the level of risk the investor is willing to take on, the investment time horizon and the life circumstances of the investors. For instance an investor who is retired will need income to fund their living expenses where as an young investor who is still working can engage in more risk as retirement is still a long way off. See below six different investment approaches.
1. Value Investing
The strategy of value investing is to find stocks that are under-priced and good value. Warren Buffet is a fan of this investment strategy. This strategy requires detailed fundamental analysis of the company. Value investors look at stocks which have a market price (stock price) which is lower than the intrinsic value of the company. Intrinsic value is defined as the discounted value of the cash that can be taken out of a business during its remaining life. This value is an estimate which is dependant on interest rate movements or forecasted cash flow. A stock price is more than the intrinsic value when there is strong demand, driving the prices up. This strategy is more suited to the long term investor as these value stocks may take a long time before their stock prices rise. Stocks with lower P/E ratios will be more favourable under value investing. A cheaper stock does not always mean a profitable stock as the business may have serious issues. Hence research on the company is necessary when evaluating a value stock.
2. Income Investing
This strategy involves buying securities that generate income for the investor. Stocks which have a high dividend yield are selected as investors are looking for income producing stocks. Bond proxies have been popular in income investing. Such stocks include real estate trusts (REITs) and listed infrastructure. These are defensive stocks but have a higher dividend yield compared to the bond market. Stocks that have a high dividend rate may not have as much capital growth appreciation as a stock that pays no dividends. The reason is that companies which forgo dividend payouts reinvest those earnings into the business for expansion. The strategy of finding companies that pay high dividends is appropriate for investors who are living off their investment portfolio to fund their living expenses. This strategy is suited to the conservative investor as companies who can pay large dividends tend to be established stable companies.
3. Growth Investing
This strategy involves selecting companies which have potential to grow rapidly in the future. These stocks may be expensive in comparison to what the company is earning currently as the market has already priced in future growth in these companies. Growth companies reinvest their earnings to grow the business further and hence may not pay a dividend at all. This strategy is more suited to the risk seeking investor as these stocks are more volatile than average. Growth stocks have the possibility of large capital growth gains if stocks are selected well. It is suited to the investor who does not need income from their investment portfolio and is willing to sacrifice income for capital growth.
4. Small Cap Investing
Another strategy for the risk seeking investor is small cap investing. This strategy is suited to an investor who does not need access to their capital for a while. A small cap stock is defined as company with a market capitalisation between $300million and $2billion. Small cap stocks have historically performed well when there are interest rate rises and the economy is strong. However large cap stocks perform better during periods of recessions. These stocks are chosen for their potential for future growth, but with a small market cap their volatility is higher. Unlike growth investing, small cap stocks tend to be priced cheaply as the business is still in its infancy. The reason why small cap stocks have a higher propensity for capital growth than stocks in the top 20 is because they are still in the growth phase of the business cycle. It’s easier for a company with market cap of 300m to double in size than a stock in the top 20.
5. Active Investing
This strategy involves frequent buying and selling of stocks to take advantage of stock volatility and stock mispricing. An active investor typically holds positions within hours, days or months. Technical analysis is more of a focus than fundamental analysis as the investor is not investing in the stock for the long-term frame. Active investors change stocks in the portfolio depending on market, economic and company conditions. These investors will cut stocks that aren’t performing or are stagnate rather than hold the stock long term anticipating the stock will appreciate in value. The purpose of active investing is to beat the market and outperform the index.
6. Passive Investing
Passive investors believe the market is priced efficiently and they hold shares which track an index. The is strategy is to match the returns of the market. These investors buy and hold securities for the long term and there less frequent trading. Stocks are only sold and brought when companies leave and enter the indices. If there are large share price drops, passive investors hold onto the stock in the hope that over time it will recover. The returns with passive investing tend me to be smaller than active investing as it seeks to track the index and not beat it. However, transaction costs are lower due to less trading.
Lauren Hua is a private client adviser at Fairmont Equities.
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