When it comes to spending money, whether shopping at a store or buying a home, it’s critical to have a spending plan. When it comes to trading in the stock market, it’s even more important to begin with an investment strategy.
If you don’t, you’ll end up with the same buyer’s remorse you feel when you walk out of a store with a few impulse purchases.
After all, you don’t want that stock you just bought to drop 15% in one day.
If you’ve already learned how to read stocks like a pro, let’s get you in the game by setting an investment strategy, which gives you a clear picture of what types of stock to choose.
There are three main principles to think about before you put your money in the stock market — your Investment Objectives, Risk Tolerance and your Time Horizon.
Do you want to save for retirement, have steady passive income, or to be able to buy a house in the next couple of years?
Determining your investment objectives is the first step to shaping your strategy.
Ask yourself what you hope to get out of these investments in the stock market and carefully plan out the money you’ll need to reach your goal.
When analyzing your objectives, make sure to assess whether they are reasonable.
Here’s two scenarios of two people in very different situations accessing their investment objectives:
Byron is a college student and has $1,000 to invest. He wants to be able to pay $3,000 of student loans off when he graduates in two years. To do this, he will have to generate $2,000 from his stock purchases in just two years. This equates to a 200% increase on the initial investment, which is very challenging to achieve — Byron will need to adjust his expectations.
Frank is more conservative then Byron. He has $100,000 that he wants to invest in the stock market and thinks he will need $800,000 to retire in 30 years. His initial investment will need to earn 8% returns every year on average–compared to Byron, Frank set a much more reasonable goal.
Navigating the risk-reward tradeoff is one of the foundations of investing.
The basic concept when identifying your risk tolerance is acknowledging that for a given reward, you will have to take on a proportionate amount of risk.
The higher the expected returns, the higher the risk is that you will lose money from your initial investment.
You need to ask yourself to which degree can you withstand varying swings in the prices of your investments.
If you are risk-averse, then you will want to invest in stocks that are more conservative.
On the other hand, if you’re a riskier investor, you may want to think about how much money you’re willing to lose for a chance at a large gain.
Here’s a tip: one way to measure stock risk is by looking at what’s called Beta, which is a statistical term synonymous with risk.
For example, a Beta of 1 indicates that the stock is as risky as the S&P 500 index.
The higher the Beta of the stock, the more volatile the price is and the greater the chance that the price will sharply fluctuate up or down.
A stock with a lower Beta is less likely to drop in price but will most likely not generate as high of returns.
You can find the Beta of a stock on financial reporting websites such as Yahoo Finance.
Based on your risk tolerance, you can use Beta as one metric to determine if a stock suits your investment strategy.
When setting your stock investing strategy, another key consideration is the amount of time you plan on holding your investment before you convert your stock into cash.
The longer the time horizon, the more risk you can take on. If there is a decline in a stock price, a longer time horizon gives the stock more time to recover.
In 1999, Amazon was a smaller, riskier tech stock then it is today.
If you invested in Amazon in December 1999 at $37 a share with a 2-year time horizon in mind, the price of Amazon would have dropped to around $10 by the time you were ready to sell.
If you invested in Amazon with a 10-year investment horizon in mind you would cash out in December 2018 when Amazon was selling at approximately $1,600 per share.
Identifying that Amazon was a riskier stock in 1999 would have saved a short-term investor a lot of hurt, and greatly benefited the long-term investor.1
Putting Your Strategy into Practice
Once you’re reasonably comfortable with your strategy, you need to make educated and calculated decisions on what stocks best suit your investment preferences.
There are three trading strategies that differ in risk, timing, and potential for capital gains — Income Investing, Value Investing and Growth Investing.
Income investing is simply investing in a security that pays you a consistent stream of income on a periodic basis.
Generally, income investing takes the form of fixed income securities such as bonds, CDs, or annuities. Stocks that pay dividends are also a form of income investing.
Companies typically pay dividends on a monthly, quarterly, or annual basis to reward shareholders for owning its stock.
Because cash dividends are paid out from a company’s profits, paying out dividends is a sign that the company is financially healthy.
Once the company begins paying a dividend to investors, it very rarely cuts its dividend — this is a sign that the company is facing financial challenges.
The most attractive income investments are those where companies have consistently raised dividend amounts, have no history of dividend cuts, and still have potential for capital growth.
Dividends not only provide a consistent stream of income, but the stock still has the upside of capital appreciation to further boost returns.
Dividend investing allows investors to amass a large among of income over the long-term and provides investors with a hedge against any declines in the actual stock price. It’s a great tool for investors looking for consistent and sustainable earnings.
Value investing is another trading strategy that focuses on stocks that are priced at less than their intrinsic value.
Value investing is about doing your research, finding a rock-solid company that is undervalued and buying its stock at a discount.
How do you find these companies?
Ideally, you want to search for large, stable companies that are currently going through a period of unpopularity — when everyone else is selling, you are buying.
The types of companies a value investor looks for meet the following criteria:
- History of dividend payments and/or price appreciation
- Large and conservatively financed
- Likely to be around long-term
- Has recently underperformed the broader market and is an attractive price
The most fundamental metric to determine if a company is valued below its intrinsic value is the Price to Earnings ratio, which is the stock price divided by earnings per share (EPS).
Simply put, it’s the price you pay for $1 of the company’s earnings.
Similar companies in the same industry will trade roughly around the same P/E ratio. When you find a company with a P/E ratio significantly lower than its peers, there’s a good chance you have found a value stock.
Benjamin Graham, the father of value investing, believed that if a P/E ratio was over 20, it was too expensive and not worth investing in.
A major tenant of value investing is to think long-term; the market is efficient in the long run and the stock price will eventually reflect its true value.
While income investing and value investing are more conservative strategies focusing on large, stable companies, growth investing is a much more aggressive approach focusing on companies that offer potential for rapid growth.
Growth investing promises huge upside potential but is riskier because stock prices are more expensive.
A growth stock may simply be defined as one that has grown in the past and is expected to do so in the future.
Growth stocks generally include companies with the following criteria:
- Competitive advantage
- Ability to scale
- Huge market opportunity
- History of growth as well as strong financials
Proceed with caution as growth stocks tend to have higher P/E ratios and offer less predictable returns.
However, Warren Buffett said it best when he said it is better to buy a wonderful company at a fair price than a fair company at a wonderful price.
Bonus: Socially Responsible Investing
Many investors prefer to invest in companies that seek to positively impact the world.
Socially responsible or impact investing is a strategy where you look to invest in companies that contribute to the well-being of the planet and humanity.
The companies span a wide range of industries and are usually environmentally friendly, ethical, sustainable, or support local communities.
Many mutual funds and ETFs track companies with high Environmental, Social, and Governance (ESG) ratings that measures a company’s impact whether they combat climate change, promote employee diversity, or increase human rights efforts.
Some mutual funds and ETF portfolios won’t invest in companies that aren’t socially responsible.
These firms include alcohol, gambling, tobacco, and fossil fuel companies.
Figure Out What’s Right for You
Now it’s time to get in the game!
Take a moment now to write down your financial goals, analyze your risk tolerance, and figure out your time horizon.
Once you have an idea of your investment objectives, identify stocks that best fit your investment strategy.
Most importantly, be confident in your abilities as you take the first step toward successful investing.
Tucker Ammons is an investment banking analyst at Bourne Partners, a boutique investment bank in Charlotte, North Carolina.