Choosing your investment strategy is probably the toughest step you will take as an investor. Not coincidentally, it is also the one investors are most likely to skip over. Like it or not, investing is a glorified form of risk taking. Despite all of the studies, spreadsheets, evaluations and computer algorithms, we never really know what will happen next in the marketplace. Since we don't have control over all of the things that can change the fortunes of a company or its stock, we need to have a plan for what we can control—and that's where your strategy comes in.
The riskiest strategy out there is probably the most common one among smaller investors. A simple form of stock picking, it involves placing all of your money in a short list of stocks that you think might be going somewhere.
This strategy usually results in some great conversations at cocktail stories. Chances are you've overheard someone chattering about how much she made on her Apple stock. On the other hand, you are a lot less likely to hear how much she lost in Mattel last year. Ouch. Stocks don't always rise and fall so dramatically, of course. But the kind of public chatter that often convinces someone to buy a stock is the same sort of chatter than sends herds of investors rushing—and sell—all at once. If you are going in as a stock picker, be ready for the roller coaster ride.
To avoid those wild swings, investment advisors diversify (invest in a wider array of securities) to prevent the disastrous scenario of having all of your money in one stock when it drops. In fact, mutual funds, bond funds and more recently, exchange traded funds (ETF's) were created to make diversification cheap and easy. Your ownership of fund shares mean that you "share" in a large pot of different investments.
We investment advisors don't just add more stocks to our list, though. We also use asset allocation. In other words, we put a little bit of money into a lot of different kinds of investments. Asset Allocation strategies recognize that large company stocks, government bonds and real estate trusts all respond differently to market conditions. By investing in different kinds of securities, we hope to make money even when certain portions of the market are losing or flat. This post gives you the basics on creating your own asset allocation model.
Whether you are investing in a single stock or creating a diversified portfolio, you are going to run into trouble unless you have a strategy in place for deciding when to buy and sell. Everyone agrees you should "buy low and sell high." The problem is knowing when an investment actually is high or low. A "contrarian" solves this by keeping track of whatever the market seems to be doing and then doing the opposite. Is Apple soaring this week? Then it's time to sell. If a stock drops, a contrarian treats this as the time to buy.
As you can imagine, there aren't a lot of true contrarians out there. There is always a chance that the stock will go just the little bit higher or lower tomorrow, so contrarian strategies often just leave investors paralyzed in the face of a decision.
This approach deserves a post of its own, if only because most investors will find it the single most confusing aspect of of the investment world. The idea of "hedging your bets" is exactly what it says. Imagine someone placing a bet and then drawing a boundary (a hedge) around the possible outcomes. If you've placed your bet on Apple stock, hoping it will continue to go up, you might also put a little money on the possibility it goes down—just in case. You could do this by purchasing (for a price) a "put." Put are contracts that give you the right to sell your Apple stock at a certain price. If you find your Apple stock has plummeted below that contract price, you exercise your option and sell the stock at the contract price, limiting your losses.
Conversely, you might decide not to buy Apple but worry that it could be going up in value. Buying a "call" option instead of a "put" gives you the right to buy those Apple shares later at the price you've agreed on. You will exercise your "call" if the Apple stock goes above the call price, which makes the stock a bargain for you.
Most investors will never directly purchase options of any kind, but you will likely have the opportunity to buy mutual funds and even hedge funds that use this as an essential part of their investment strategies.
Over the past 20 years or so, a more radical approach has emerged to solve the problem of timing in the stock market. Increasingly investors are using index funds to avoid questions of when to buy or sell almost entirely. Under this strategy, you follow the markets, rather than the securities in them. An index fund has a little bit of whole lot of stocks from a particular category. The most popular of them follow well known indexes like the S&P 500 or the Dow Jones. Since your index fund has shares of just about everything on the index, you are counting on particular shares to rise—just that on average the whole index goes up. Index investing is essentially a bet that the global economy will continue the pattern of long term growth we've seen historically. An index investor just sits back to enjoy the ride.
Does index investing work? Well, so far it does. We use it at Revolution Capital, and while we still can't tell you what the markets will do tomorrow, we feel good about research that shows index investing generally wins out over even seasoned experts in the long run. If you want to read more on the research into index investing, Vanguard regularly updates their research on the subject).
So which strategy is best? You will find experts out there who swear by each of these strategies, and none of us can tell you the 'right' answer. What's important is finding the right answer for you—and then sticking with it.