Welcome back to the second part of our investment lexicon series.
By now you have a good understanding of what the market is, how the stock market works, and different methods of tracking market performance. Now it’s time to look at some key tools to keep in mind when investing in the stock market.
Remember, each strategy has its pros and cons so the best way to maximize them is working with a financial planner who’ll help your portfolio reflect the right risk with your financial goals. Let’s jump in.
Diversification is a risk management strategy that seeks to ensure your portfolio isn’t over- or underexposed in a certain area. The goal of diversification is for your portfolio assets to balance each other out by maximizing profit and minimizing risk. This is done by ensuring the securities in your portfolio react differently to market conditions in order to maintain that balance.
You can diversify your portfolio across asset classes, within assets, and also geographically (think both domestic and foreign markets). The easiest way to view diversification is in terms of asset classes. Just think, your portfolio could be a mix of stocks, bonds, commodities, real estate, exchange-traded funds (ETFs), and more. Adding another layer, the stocks in your portfolio can be across economic sectors like pharmaceuticals, finance, and petroleum.
Building on diversification, asset allocation is an investment strategy that builds your portfolio by weighing an adequate amount of risk for your goals. Asset allocation evaluates how your portfolio is created and the specific securities you are investing in. For example, a more aggressive portfolio might have 80% stocks and 20% bonds.
These stocks and bonds can also be diversified across industries and other markets — so asset allocation and diversification are not mutually exclusive, rather, they work in harmony.
This strategy helps curb a bad financial habit: timing the market. Dollar-Cost Averaging (DCA) allows an investor to divide the total amount of investment money into smaller, periodic purchases. The goal is to avoid market timing, harness volatility, and hopefully see a better return.
DCA is a great long-term strategy that helps investors build wealth over time. One prime example is a 401(k). You make payroll contributions to this account on a cyclical basis which distributes funds to your portfolio and increases your savings over time. But this strategy can also be used outside of retirement savings accounts like mutual funds or ETFs.
High-Level Investment Strategies to Keep in Mind
Investment strategies are really the fun part. They allow you to customize a plan based on your unique needs and let you approach investing in a way you’re most comfortable with. Let’s review a few that are ideal for new investors.
Active vs Passive Investing
These are two completely different approaches to money management. Each has its pros and cons, though many professionals today encourage the lower-cost passive form of investing.
Active investing is what it sounds like: it actively approaches buying, selling, and trading securities to earn maximum return. This type of investing requires a portfolio manager and often a team of analysts who alter, adjust, and move securities in real-time with the goal of a larger return.
But this type of investment philosophy has some significant downsides. To start, the management fees alone are often overwhelming, not to mention the added fees for buying and selling assets. There are also important tax considerations with this approach which usually results in a higher tax bill.
Passive investing, on the other hand, is a sound alternative that has been proven to match or outperform its active counterpart. Whereas active investing is attuned to short-term market fluctuations, passive investing is a long-term plan. With a passive investment approach, the actual buying and selling of securities is limited and investors rely more on long-term projections than market timing.
Passive investing has many benefits including low cost, increased transparency, and tax efficiency. But critics say it isn’t as flexible and doesn’t offer as great of returns. Active investing gives the investor more freedom to potentially see larger returns, but it also incurs much higher fees and risk.
Growth vs Value
Another dichotomy in the investment world is the difference between growth and value approaches to investing. While both growth and value are desirable aspects of any portfolio, many investors lean one way or another depending on their needs.
A growth investment strategy focuses on companies that are predicted to grow faster than the rest. The hope is the company will grow through additional hires and acquisitions which will lead to added profit, but that isn’t always the case. This style of investing carries more risk and is better suited to investors with a high-risk tolerance and a long investment time horizon.
Value investing takes a different approach. This type of investment looks for companies who fly under the radar, meaning their stock price might not actually represent the true value of the company. Value stocks tend to be safer investments and usually pay dividends to shareholders.
Essentially, growth stocks, since they are more established and more expensive, carry greater risk. Value stocks tend to be more cost-effective and have less risk attached. The type of stock that is right for you comes down to your risk tolerance, investment goals, tax plan, and investment horizon.
Building Your Strategy
There are many different investing strategies out there, and you need to find one that supports your unique goals. Each person’s investment needs may change, so it’s important to know the different ways you can invest. Remember, you can always alter your investment plan as your needs evolve.
In fact, it’s important to update your plan as you move through significant life stages. This is where working with a financial planner helps. Together, you can evaluate short- and long-term goals and adjust strategies based on your current life stage. Want to learn more? Reach out! We’d love to talk to you.
Stay tuned for our next series installment, where we’ll explore the different types of investments in your portfolio!