As a trader or investor, you can choose from a wide variety of styles of investing in the stock market - which one is right for you? Before you start trading or investing, there are a few key questions you need to answer before deciding on an approach that suits your personality and your financial situation. Of course, the investment style you adopt should also match your investment goals.
Here are some of the things you first need to figure out:
Only you can decide which style is best for you. Below, we'll examine the pros and cons of each approach and give you an overview of the various stock picking approaches.
Are you ok with taking risks? Do you like to trade several times a day every week? If so, then an active investing style is probably right for you since you don't really have a long-term horizon, but prefer to focus on current scenarios. Active traders typically target specific stocks and take advantage of market timing to trade stocks and earn short-term profits. Active investing requires you to constantly monitor the market to improve your position and achieve the best results.
There are many benefits to active investing, but the most important one is the flexibility it provides you with. When an asset falls below par, you have a free hand to change your position and this gives you more control over your portfolio. If you need to take sudden or drastic action, like for example hedging short sales or setting options to avoid losses, you can do it quickly and easily on your own.
The downside is the fees you have to pay each time you make a trade, both for buying and selling your shares. Although transaction fees vary from market to market, they can quickly add up to a substantial amount. And they can eat into your profits.
And let's not forget about fund manager fees! At first glance, they don't seem too heavy, because we're talking about 1.5%. Except when you pay 1.5% over a 15-year period, that's pretty significant. And 1.5% is the average rate, which means that there are fund managers that charges more. You should also pay attention to entry and exit charges.
These are the biggest drawbacks, but there is one that beats them all. After paying all of these fees and costs, you still won't know if you're doing better than the market. In fact, 70-80% of active investment funds fail to beat the market. At the end of the day, if you've factored in all the fees you've paid, you might end up in the red. It will be too late when you realise that you have lost money.
Have you considered passive investing? This means that you're investing for the long term. A passive investor limits the amount of buying and selling in order to minimise costs. This strategy requires: 1) a willingness to buy and hold stocks, and 2) the discipline to resist the temptation to react or adapt to the stock market's perpetual movements.
A passive approach example would be the buying of an index fund. But make sure it's a fund that tracks one of the major indices like the DAX 30 or the FTSE. The principle is that you become the owner of small fragments of thousands of shares of companies and you earn your living as a participant when the profits of those companies increase over time. Successful passive investors simply keep their eyes on the price at the end of the investment period, and don't get sidetracked by short-term setbacks and even market downturns.
The advantages: Time and flexibility
One major benefit is all the time you save. The process is simple: you invest your money and then go off and do something else! You don't have to analyee economic and financial news every day or follow the evolution of your stocks. So, basically, it doesn't take a lot of time and thought.
With that being said, now let's talk about the fees you save when you buy and sell. While the actual fees depend on where you invest your money, they can be as low as 0.09% per year. The upper part of this scale would be about 0.6% per year. If you compare that with what you have to pay for other active investing programmes, that is enough to make you feel good about yourself!
The other benefit that many investors ignore about passive investing is that it also leaves some leeway. This means that the decision you make today won't remain permanent for the next 25 years or so. You have the option to review your investment strategy after a few years. You can invest in high risk options for five years for higher returns, switch to a different mix for the next ten or so years, and then go for a low risk portfolio when you near retirement.
The drawbacks of passive investing
Do you know what a lot of investors don't like about passive investing? It's that long period of inactivity and waiting. This is especially true when they see their stocks underperforming their expectations and feeling the need to sell them quickly. The truth is, setbacks are normal in passive investing, so investors should expect them. You need to have a long-term perspective and be confident that they will eventually come back up. If you still worry after this, we can't blame you, it's human nature.
Another drawback of index investing is the composition of an index. Any business, whether doing well or not, can find its way to the index. So it's possible that there are losers in the mix and you are putting money into them anyway. Of course, if your investment is doing well overall, it outweighs the bad ones in the index.
Growth investing is based on using growth stocks to make long-term profits. Basically, growth stocks are those that the investor sees as good prospects for future returns because of the company's potential to generate increasing income every year. The principle is that the growth of the company's profits will increase the price of the stock.
Generally, you should choose those that have the capacity to grow faster than the overall market. You can see this by looking at the company's track record and making an informed estimate of its future performance. Potential growth depends on factors such as industry, geography, asset class, regulation and, for cyclical industries, where it is in its cycle.
This is basically a dual bet. As an investor, you're betting on a stock that has already shown above-average growth (whether earnings, income, or some other metric) and which you think will continue to do so, which makes it a strong candidate for you to buy. These are companies that are leaders in their own industry, have above average P/E ratios and often pay low (or even zero) dividends. However, if you buy at a high price, there is always the risk that an unexpected event will cause the stock price to fall.
Value investors are kind of like treasure hunters. They are looking for hidden gems, or stocks that are cheap but very promising. The reasons why these stocks are undervalued can vary, such as a short-term PR crisis or a more permanent situation such as an industry-wide crisis.
Value investors look for undervalued stocks within a specific industry or across the market, hoping that the price will rebound when other stocks start to rise. In general, these stocks have a low P/E ratio (which is an indicator that helps determine the value of a company) and a high dividend yield (the proportion of dividends that a company pays in relation to its share price). Of course, the price may not rise at all, which is a real risk.
Investors need to avoid the value traps - a company that looks cheap on paper, but can't turn around and gain value. Instead, you should invest in companies whose bad situation is short-lived and whose potential for turnaround is real.
One more thing you need to ask yourself relates to the size of the companies you will invest in, which technically depends on its capital, which investors refer to as its "market capitalisation" or "market cap".
Investors who choose stocks based on the size of the company use an investment style based on market capitalisation. The calculation of market capitalisation is the number of shares outstanding multiplied by earnings per share. Small-cap companies have a market capitalisation of £250 million to £2 billion, mid-cap companies have a capitalisation of £2 to £10 billion while large-cap companies have a market capitalisation of over £10 billion (or $ or €). In terms of risk, small cap stocks are riskier than large cap stocks.
However, you may come across investors who believe that small cap companies have greater potential to deliver better returns, simply because they have more leeway for growth opportunities and can react faster to changing market conditions.
In reality, the return potential of small caps is proportional to the amount of risk you're willing to take. On the one hand, small businesses have fewer resources and often have less diversified activities. Their stock prices can fluctuate much more widely and can result in significant gains or losses. Therefore, if you are this type of investor, you should be comfortable with this additional level of risk if you want to take advantage of greater potential returns.
Large cap companies have been around much longer and are generally more stable. Many investors keep large cap stocks in their portfolios because of both their dividends and their stability.
The stock investment style that's right for you starts with an honest assessment of your risk tolerance. Remember that the basic principle of investing, namely risk and return, is: the higher the risk, the higher the return; the lower the risk, the lower the return. And "risk" means possibly losing money.
Your age, income, background and personality are the most common characteristics that affect your risk tolerance. Younger investors are more aggressive and tend to choose riskier investments, while older ones generally choose safer investments. New investors and people with a small budget are generally more conservative than those with more disposable income. In addition, some people like taking risks and others prefer investing slowly but surely.
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