Understanding the way you react in situations of uncertainty can provide a lot of insight into how you deal with money. Have you, in your years of being in markets, narrowed down onto some styles of investing? Or maybe you haven’t given it thought. Narrowing down onto one definition of what you are in terms of preferences may help clear a lot of agony and discussions when you come across people and stock ideas as it would be closest to your personality. This not only applies to stocks but to mutual fund picks as well.
As Warren Buffett says, “Success in investing doesn’t correlate with I.Q. … what you need is the temperament to control the urges that get other people into trouble in investing.”
Active or Passive Management
Do you believe you want to give your money to experts, which may include yourself, or you believe you are in it for the long haul and the India story is what will drive returns and want market exposure and not the alpha!
Investors who hire active management professionals are termed active investors though of course you need to pay for the expertise of this staff. But if you doubt the abilities of active managers or go by some research that shows that over the long run, many passive funds earn better returns for their investors than actively managed funds you may actually be termed a passive investor.
A buy and hold OR index investing style falls under the umbrella of passive investing. An investor who is engaged in buy and hold investing rarely trades in their portfolio and is mostly concerned with long-term growth.
Bottom-Up vs. Top-Down
A top-down investor looks first at economic factors and then selects industries accordingly. For example, during periods of low inflation, consumer spending increases, which might be a good time to buy automobile stocks or retail stocks. The top-down investor would then search for the best values in these industries. A bottom-up investor is more concerned with individual companies’ fundamentals. They reason that even if its industry is doing poorly, a hot company will still outperform the market. Both of these styles emphasize fundamentals, but place different emphasis on the economic environment.
Growth or Value Investing
The next question investors must consider is whether they prefer to invest in fast-growing firms or undervalued industry leaders.
The growth style of investing looks for firms that have high earnings growth rates, high return on equity, high profit margins and low dividend yields . It is thus growing very quickly, and reinvesting most or all of its earnings to fuel continued growth in the future and will multiply in size within its given environment. These stocks are oftentimes referred to as being overvalued and have a high price to earnings ratio.
On the other hand, the value style of investing is focused on buying a strong firm at a “good” price. Thus, analysts look for a low or relatively low price to earnings ratio, low price to sales ratio, and generally a higher dividend yield. The main ratios for the value style show how this style is very concerned about the price at which investors buy in.
Contrarian investors are another type of value investors and they like to go against the herd. Either buying stocks that everyone hates or going against what the investing crowd does. When the market dies, they buy. Most of the time, they just sit quietly in the wings, waiting for the opportunity to buy on dips.
Small Cap or Large Cap Companies
The final question for investors relates to their preference for investing in either small or large companies. The measurement of a company’s size is called “market capitalization” or “cap” for short. Some investors feel that small cap companies should be able to deliver better returns because they have greater opportunities for growth and are more agile. However, the potential for greater returns in small caps comes with greater risk. These share prices can vary much more widely, causing large gains or large losses. Thus, investors must be comfortable with taking on this additional level of risk if they want to tap into potential.
More risk averse investors may find greater comfort in more dependable large cap stocks. These companies may be unable to grow as quickly as their smaller peers, since they are already so large. However, they also aren’t likely to go out of business without warning as they have commanding positions in their sector.
There is another style called the Pursuer: These personalities are quick decision-makers and will try most anything at least once. However, because pursuers tend to be fast-thinkers with short attention spans, they are constantly looking for the next best thing and have trouble sticking with their decisions and tracking their investments over the long term. Pursuers are the type of investor who would be most likely to buy high and sell low. Be careful you aren’t one of them!
The Bottom Line
Clearly defining the investment style that fits you will help you select investments that you will feel comfortable holding for the long term and allow you to apportion allocations in the right brackets so volatility or market declines don’t scare you any more!