Learn about investment strategies, asset allocation and risk tolerance
What are the different kinds of investment strategies?
The methods that people use to try to get strong returns and greater capital appreciation from their investments are called investment strategies. Understanding the different methods and the factors that you need to consider when choosing them is important when learning about investing for beginners.
The best investment strategy for you might not be the one that has the highest returns and the greatest potential capital appreciation on a historical basis. Instead, strategies differ depending on your risk tolerance and goals.
There are several different types of strategies, including the following:
- Fundamental analysis
- Technical analysis
- Value investing
- Buy and hold
- Growth investing
- Income investing
- Small cap investing
- Reinvest dividends plan
We will explore each of these different types of investment strategies so that you can gain a better idea of which approach might be appropriate for you as you work to build wealth and to realize capital appreciation.
What is asset allocation, and how does it apply to investment strategies?
Asset allocation refers to the apportionment of the capital assets in your investment portfolio in a way that balances the risks and rewards. The goal is to apportion your securities in a way that matches your risk tolerance and your financial objectives and goals. It is a key factor in your investment strategies.
There are three main types of assets, including equities, cash and equivalents, and fixed-income assets. Each of these three main classes has a different risk level and return, and each performs differently over time. Achieving the right balance for your goals and time horizon is important when you are building your investment portfolio with an aim at attaining strong capital appreciation.
Statistics on saving and investment trends
In a study of financial literacy, participants were asked five questions that covered the basic principles of finance that are used in daily life. Thirty-seven percent of the participants answered three or fewer of the questions incorrectly, pointing to a need for greater financial literacy. Only 46 percent of people reported that they had taken the efforts to have savings for emergencies.
Across the U.S. adult population, 55 percent of people report that they had investments in the stock market. Many people who have investments in the stock market hold their investments in employer-sponsored retirement plans or IRAs while a much smaller percentage have taxable brokerage accounts in addition to these types of retirement accounts.
How do I determine my investment strategy?
The first step in learning how to invest money is to figure out the strategy that you will use. You need to figure out which approach is right for you. Begin by defining your investing goals. For example, are you working towards making a large purchase in the next few years? Are you saving for retirement? Are you trying to build a side income? Each of these different types of financial objectives is important and may affect the investing strategy that you ultimately pick.
Figuring out the proper asset allocation is an important part of the process. Several factors will play a role in how you decide to distribute money among the different asset classes in your investment portfolio. You should look at your timeline and when you will need the money, which will involve an evaluation of your goals.
Short term goals, medium term goals and long term goals
Short-term goals are financial goals that will take between one and five years for you to achieve. Long-term goals are those that have 10 or more years left for you to save for such things as your eventual retirement. Mid-range goals are those objectives that fall somewhere in between such as saving up money to make a sizeable down payment on a first home. You will allocate your assets differently depending on your objectives and the time frames that you have to meet them.
Your ability to tolerate risk is another important factor. If you have a long period of time to save and invest, you are able to be more aggressive. Aggressive investment strategies have a high-risk/high-reward proposition. The stocks typically have a high beta or sensitivity to the overall market. High-beta stocks consistently experience larger fluctuations in comparison to the market.
A moderate or medium risk tolerance is appropriate if your time horizon is longer than five years but less than 10 or more years. A conservative risk tolerance is appropriate when you have a short time frame to achieve your financial objectives. In general, your investment strategy will become more conservative the closer that you get to your planned retirement age.
Defensive stocks normally do not have a high beta and are fairly isolated from broad movements in the market. By contrast, cyclical stocks are securities that are the most sensitive to the underlying economic business. The benefit of buying cyclical stocks is that they offer an added layer of protection against adverse market events.
Finally, figuring out what type of investor you are is important when you are evaluating different investment strategies. Active investors have a goal of making short-term profits through continuous buying and selling of securities. The benefits of this approach include that it allows adjustments of your portfolio to align with the prevailing market conditions for the management of risk and also offers short-term opportunities with short-term trading.
Active investors and passive investors
Active investors may pay high or low fees. High fees occur when active investors pay per trade through traditional brokerages which tend to incur higher fees than those who use modern, online platforms and pay lower fees.
Passive investors have a goal to match the market’s return and keep costs low. Passive investing involves less buying and selling. When you engage in passive investing, you might buy and hold investments, which is called set it and forget it investing or a lazy portfolio.
Semi-passive, a hybrid approach, or passive investors who use traditional brokerages can be charged with commissions and management fees while those who rely on independent or self-managed tools can enjoy low or no fees when investing online. The benefits of this strategy can include tax efficiency since passive investing normally does not result in a large yearly capital gains tax.
Passive investors may also use dollar cost averaging, which is an approach to investing in which investors contribute equal amounts to their investment portfolios at regular intervals. With dollar cost averaging, you will end up purchasing more shares when prices fall, and fewer shares when prices go up.
Another type of investing that is passive in its approach is index investing. Index investing is a strategy in which investors try to obtain returns that mirror the performance of an index by purchasing shares of an ETF fund that tracks the index.
Different types of investment strategies and how to invest money
There are multiple types of investment strategies that you can use. By taking into account the previously mentioned factors, you can make a more informed decision about which approach might work best for you, for your time horizon, for your risk tolerance, and for your financial objectives.
Fundamental analysis is one of the oldest investment strategies. Investors who use fundamental analysis employ an active investing strategy in which they analyze financial statements in order to select quality stocks.
Investors who use a fundamental analysis compare the information on the financial statements with current and past data from the business and other similar businesses within the industry. This analysis and comparison help the investors to determine a proper valuation of the stock so they can figure out whether it is a good buy.
Technical analysis is an investment strategy that is almost the inverse of fundamental analysis. Technical analysts use charts to help them to recognize current market trends and price patterns. The idea behind technical analysis is that recent price patterns are good predictors of future trends and that share prices tend to go in the same trajectory that they are currently following.
Technical investors watch for the patterns. When they form, the investors rely on them to make investment decisions based on their expectations of the potential outcomes of the patterns. Some common patterns may be given names to describe them visually, including cup and handle or head and shoulders.
A cup and handle pattern is one in which the chart looks like a cup with a handle. The portion that looks like a cup is in the shape of a U while the handle goes in a downward direction. This depicts the price drop and a rise back to the investment’s original price. This is only one of the technical methods that can be used in conjunction with other methods in determining when to invest.
A head and shoulders pattern is a pattern that forms when a trend is going through a reversal. It forms two smaller spikes with a central larger spike that roughly look like shoulders and a head. Investors who see this pattern starting to form prepare for a decline in prices.
Value investing is an investment strategy in which investors try to find stocks at bargain prices. This strategy involves choosing stocks to purchase that appear to be trading for less than their true or intrinsic values. Warren Buffet is a proponent of this type of investing approach. Some investors purchase shares of exchange-traded funds that hold value stocks to engage in this type of investing.
Others look for below average price-to-book ratios, price-to-earnings ratios that are lower than average, and dividend yields that are higher than average. These factors are believed to help investors to identify value stocks.
Buy and hold investors
The buy and hold investment strategy involves purchasing securities and holding them for longer time periods. Investors who use this type of strategy operate under the belief that long-term returns can be healthy despite the volatility of the securities during short time periods. This approach is also called a lazy portfolio.
People might use a core and satellite approach in order to identify an overall good investment. With this, there is a core that might consist of a large-cap stock index mutual fund. It will also have satellite funds that are made up of smaller portions of the portfolio. This approach reduces risk through diversification with the goal of outperforming a standard performance benchmark such as the S&P 500 Index.
Under modern portfolio theory, the portfolio is made up of diverse investments that have varying levels of risk that combine to achieve a return that is reasonable. Post modern portfolio theory, or PMPT, utilizes the downside risk. It estimates a stock’s potential to fall in value if market conditions were to change.
Tactical asset allocation uses the three primary asset classes, including stocks, bonds, and cash and equivalents. The investor actively balances and adjusts the assets from these classes with the goal of maximizing the returns and minimizing the risk as compared to a benchmark. The focus is primarily on asset allocation with a secondary focus on the selection of investments.
Growth investing is an approach in which the investor focuses on growth stocks. Growth stocks are those from companies who have earnings that are expected to grow at a rate that is above the average when it is compared to the overall market or to its industry sector.
Growth investors may use momentum investing strategies in which they capitalize current price trends by expecting that the momentum will continue in the same upward or downward direction. The aim with momentum investing is to buy high and to sell even higher.
Income investing is another popular investment strategy. Investors who use this approach buy securities that tend to pay out returns on a regular schedule. Some examples of these types of securities include the following:
- Dividend-paying stocks
- Mutual funds
- Exchange-traded funds
- Real estate investment trusts or REITs
Other investment strategies
Small-cap investing is a strategy in which investors purchase stocks of smaller companies that have smaller market capitalizations. Normally, these companies have market capitalizations ranging from $300 million to $2 billion. Small-cap investments are considered to be riskier than large-cap stocks. However, some smaller company stocks have good growth potential and may be included in portfolios of nearly all but very conservative investors.
Finally, investors might engage in DRIP investing, which stands for a dividend reinvestment plan. Under this strategy, investors who engage in DRIP investing purchase dividend-paying stocks. When they earn dividends, the dividends are automatically reinvested to purchase more stock.
After you have selected your investment strategies and have started the process of building your portfolio using your chosen asset allocation model, it is important for you to understand portfolio management. This is the process involved with analyzing each individual investment that is included in a group of investments. The goal is to reduce diversifiable or non-systematic risk.
Systematic risk is risk that affects a specific industry or an entire market. Unlike a systematic risk, a non-systematic risk is a risk that affects a particular company.
Using an appropriate asset allocation model is important. You should diversify your investments among different companies to reduce the applicability of non-systematic risk to your portfolio. This is because non-systematic risk only applies to individual companies rather than across different businesses.
After you have chosen the investment strategies that match your risk tolerance, objectives, and time frame you want to construct your investment portfolio with the appropriate asset allocation. Include investments that are a diversified group of capital assets and make certain to contribute regularly. It is a good idea to choose a specific date each month to contribute to your portfolio in order to establish routine savings.
You can choose an amount to invest each month through dollar cost averaging and set up an automatic transfer of funds from your checking or savings account into your investment account. Automating your investments can help you to stay on track and to learn to live on less while you save. If you also make a habit of reinvesting your dividends, you might enjoy greater capital appreciation over time.
It is important for you to revisit your investment portfolio on a regular basis. Some people choose to check their portfolios each quarter while others do so annually. You should check whether your securities are meeting their target allocations. Rebalance and reallocate your investments as needed to reach your target allocations for your risk tolerance level.
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