When you're ready to start investing your money, rather than simply saving it, it’s important to remember that there is not a “one-size-fits-all" approach. The investment strategy or style that works for you may not be what works best for your spouse, parent, or best friend.
Asking the right questions can help you determine which path to take when pursuing investment goals. For example, are you a risk-taker, or are you risk-averse? Are you looking for long-term growth or immediate gains? Are you planning to be a do-it-yourself investor, invest through a robo-advisor, or hire an investment advisor?
This kind of reflection can help you to match your needs to a specific investing style. With that in mind, here are eight ways to invest, depending on your focus.
1. Active Investing
An active investing style might be right for you if you have a higher tolerance for risk and keep a close eye on market trends and movements. Active investing is generally used by investors who aren’t as concerned with the long-term horizon as they are with the present. With this strategy, you select specific stocks and use market timing to try to outperform the market to seek short-term profits.
One risk to avoid with active investing is attempting to chase returns based on things like recency bias, which assumes that a stock or investment's recent performance will continue.
2. Passive Investing
If you are more risk-averse and don’t want to stare at the market screens on your computer all day, a passive investing style may be more up your alley. Passive investors are those who invest their money with a long-term time horizon. Instead of trying to time the market like an active investor, passive investors create portfolios that track a market-weighted index or portfolio. Tracking an index will generally result in reduced risk due to diversification as well as lower transaction costs due to low turnover.
The growth style of investing is one that focuses on stocks of companies whose earnings are growing faster than most other stocks and are expected to continue to grow. These stocks are often referred to as being overvalued and have a high price-to-earnings ratio. It is important to note that these stocks generally pay either a low or no dividend but have the potential to make up for that with strong return performance.
Unlike growth investors who seek out overvalued securities, value investors look for those stocks that are out-of-favor or undervalued. Value investors expect that these securities will rise and seek to buy them before they do. This investing style has been popularized by hedge fund manager Warren Buffett, who argues the merits of purchasing stocks that sell for less than their intrinsic value based on the premise that they'll deliver consistent returns in the future.
5. Market Capitalization
Those investors who select stocks based on the size of the company are using a market capitalization investing style. Market capitalization, or market cap, is computed as the number of shares outstanding multiplied by earnings per share. There are three broad market cap categories to incorporate in your investing style: small-cap, mid-cap, and large-cap.
Small-cap companies have a market capitalization of $300 million to $2 billion, mid-cap companies have a market capitalization of $2 billion to $10 billion, and large-cap companies have a market capitalization of over $10 billion. Microcaps fall under the $300 million mark, while mega-caps are the largest companies by market capitalization.
Small-cap stocks are generally riskier investments than large-cap stocks. While their returns may be higher, their volatility is also higher. On the other hand, large-cap companies are those that have been around a much longer time and tend to be more stable. Many people use large-cap stocks in their portfolios because of their dividends and stability.
6. Buy and Hold
A buy and hold investing style falls under the umbrella of passive investing. An investor who is engaged in buy and hold investing will trade in their portfolio infrequently. They are mostly concerned with long-term growth. The idea behind buy and hold is that you buy into a stock while its price is still low to benefit from price appreciation over time.
Another popular form of passive investing is indexing. With this style of investing, an investor creates a portfolio that mirrors the companies of a particular stock index. The portfolio generally will perform in line with the index. This kind of investing is good for people that are more risk-averse because of the diversification of the index. The costs, including transaction costs and taxes, related to managing these kinds of the portfolio are relatively low in large part due to less turnover.
Indexing can be accomplished by investing in index mutual funds or exchange-traded funds, which track the performance of a benchmark index, such as the S&P 500 or the Nasdaq. ETFs tend to be more tax- and cost-efficient compared to traditional index funds.
There are two kinds of risk that every investor must be concerned about: systematic risk and unsystematic risk. Systematic risk is a market risk that cannot be diversified away. But unsystematic risk, or the risk that comes from investing in one particular company or sector, can be diversified away. For example, if you were to invest only in technology companies, you would have a high level of risk due to owning stocks in only one sector. By diversifying your portfolio and adding in or replacing some of the technology companies with consumer goods companies, your risk level would be reduced.
Which Investing Style Will You Choose?
There is no right or wrong investing style to pursue. The one that ultimately works best for you depends on your risk tolerance, the time horizon for investing, age, and investment goals. Remember that your investing style isn't set in stone either. As you grow older and your investment objectives change, so may your preferred investment approach.