The short version
- If you want to become a purposeful investor, it's important to choose your overarching investment strategy.
- There is no one-size-fits all investment strategy, but there are a few popular ones that many investors find work for them.
- Value investing, growth investing, momentum investing, and dollar-cost averaging are four of the most popular strategies for stock investors.
What is an investment strategy?
An investment strategy is a plan on how to invest to achieve your desired financial goals. Each individual investor will have a slightly different risk tolerance and time horizon. And these variables impact which investment strategies are most fitting.
Young investors, for example, may be more comfortable with riskier strategies since they have more time in the stock market ahead of them. Those who are approaching retirement, on the other hand, may want to choose a more conservative approach. Still, others may be interested in socially-responsible investing.
Why you should have an investment strategy
Determining your investment strategy helps you build a portfolio that matches your risk tolerance and goals. It can also help you find the investing approach that's consistent with the level of involvement you'd like to have in choosing your portfolio's underlying investments.
A mostly passive strategy takes less time than an active strategy. It involves making regular contributions to a basket of stocks in your portfolio (dollar-cost averaging), investing in passive index funds, or using robo-advisors.
If you want to be more involved and employ an active investing strategy, you could use a growth investing strategy and seek out individual fast-growing companies, hunt down bargains like value investors do, or perform technical analysis for momentum investing.
Four types of investing strategies
Every investor is unique. Some have a high risk tolerance while others don't. Your age, income level, investing goals and time until retirement are all key factors in determining your investment objective. Below are four common types of investing strategies.
1. Value investing
In 1934 Benjamin Graham and David L. Dodd published Security Analysis. This text laid the intellectual foundation for what would come to be known as “value investing.”
Legendary investor Warren Buffett was mentored by Graham and was heavily influenced by the principals laid out in his text. Value investors like Graham and Buffett hunt for undervalued stocks and typically avoid investing in new things and jumping on the latest trend.
Value investors find bargains by analyzing the intrinsic value of a security and comparing it to its current market value. If their estimate of the security's intrinsic value is higher than its stock price, they may invest.
This strategy is based on the theory that a degree of irrationality exists in the market that results in stock prices being significantly under- or over-valued. By analyzing metrics (such as P/E ratio, debt ratios and profit margins) and conducting discounted cash flow analysis, value investors seek to determine the intrinsic value of a security.
Find out more: How to Find Undervalued Stocks
2. Growth investing
Growth investing involves investing in newer, smaller companies that are able to grow faster than their peers. Investors who use this strategy usually look for the next disruptor. This strategy does not neglect the fundamentals of a company or industry. Instead, a growth investor emphasizes the future earnings of companies.
The securities that growth investors bet on are often expensive in the eyes of a value investor. But the growth investor is willing to pay for a higher current valuation due to the company's growth prospects. They anticipate that the future growth will make up for the high price they pay.
An example of a growth strategy would be Cathie Wood's ARK Innovation ETF (NASDAQ:ARKK). As an actively managed exchange-traded fund (ETF), it invests in companies that are seen as disruptors in their industry. However, this strategy can be subject to a lot of volatility. If the companies don't achieve expected growth, they can drop sharply in share price.
Read: Growth Stocks vs. Value Stocks
3. Momentum investing
Momentum investing tries to take advantage of market volatility. They ride the waves of short-term trends. These investors profit from various trends typically identified by technical analysis and various market catalysts.
A common arsenal for a momentum investor is technical analysis. They use it to identify trading patterns in a stock's price. And if they identify a pattern that signifies an increase is coming, they'll buy. Then they exit their position when a different pattern signals a coming decline.
Typically, momentum investors are constantly watching stock charts. And they're usually looking for short-term profits as opposed to long-term gains.
In the past, brokerage fees associated with constant trading were a potential downside of this strategy. But, thankfully, most of the top stock brokers today no longer charge trade commissions on stocks or ETFs.
4. Dollar-cost averaging (DCA)
Psychology and managing your emotional state are essential factors in becoming a wise investor. Many amateur traders have had the experience of dumping a large sum into a stock that they believed had hit bottom, only to see it continue to drop. They then panic and sell and lose money.
DCA investors put a preset amount of money into their portfolios on a regular basis. This means that they purchase the underlying investments at various price levels and thereby lower their cost basis over time. This way, they reduce the risk associated with market volatility. Others may choose to use robo-advisors since they will automatically allocate each recurring contribution in a way that matches an investor's risk tolerance.
DCA can be used with other methods like value investing and growth investing. If you decide to invest in XYZ company stock for the long term, you could choose to commit a few hundred dollars every month to increase your position. It doesn't matter whether you choose XYZ company stock for its growth potential or its intrinsic value.
Find out more: Dollar-Cost Averaging Guide
How to choose your investment strategy
The investment strategy you choose really comes down to your risk tolerance. Factors like age and income are factors because they influence your risk tolerance. A healthy 25-year-old with a large savings account and high disposable income has a much higher risk tolerance than a 55-year-old with kids about to start college.
Which investing strategy is a good fit for you?
Risk tolerance has a massive influence on determining your investment strategy.
- Higher Risk Tolerance — For someone with a high risk tolerance, individual stocks offer the potential to capture huge gains, but you can also lose big if your analysis is incorrect. Using stock options is another strategy that is a potentially profitable choice for those with high risk tolerance. If you are looking for an investment that's more diversified, mutual funds and ETFs offer a basket of assets. It's worth noting that funds can vary greatly in terms of risk profile depending on what the funds' investment policy is.
- Lower Risk Tolerance — Bonds can be a relatively low-risk option that offers consistent cash flow. Cash investments, like a savings account, are also very low risk. But while keeping all your money in low-risk investments, inflation eats away at the value of your money over time.
What does age have to do with which investment strategy you choose?
When it comes to age and investment strategy there is a general rule of thumb. To determine the percentage of your portfolio allocated to stocks, take your age and subtract it from 120.
For example, if you are 30 years old, 120 – 30 = 90. So your investment portfolio would be 90% stocks and 10% bonds. But this “rule” should be used as a guideline, not an immutable law. This is because it doesn't take into account personal circumstances or market conditions.
Age isn't the only factor influencing your risk profile. A 65-year-old retiree could have a high risk tolerance if they have a spouse with steady income, a large savings account and children who are independent. Meanwhile, a 28-year-old with a lot of debt, a serious health condition and a newborn has a lower risk tolerance.
Age should be used as a general guideline for determining your investment strategy. But your investment strategy does not depend only on your age. Other factors such as your job, family and other personal circumstances also impact your plan.
Regardless of the strategy that you select, be consistent with how you invest. If you choose a value investing strategy, for example, you may need to pass on that fast-growing (but over-valued) tech company. And if you choose a dollar-cost averaging approach, you really shouldn't be trying to trade stocks based on news events.
While you may be able to successfully combine two of these four strategies, attempting to use all of them is likely to just lead to confusion and a lack of focus. Rather than trying to do it all, start with just one strategy and align all of your investing decisions with it. And if, over time, you begin to feel that the initial strategy you choose isn't the right fit, you can always tweak it or even switch to a completely different approach.
Disclaimer: The content presented is for informational purposes only and does not constitute financial, investment, tax, legal or professional advice. If any securities were mentioned in the content, the author may hold positions in the mentioned securities. The content is provided “as is” without any representations or warranties, express or implied.