Introduction to investing strategies #2

Introduction to Investing Strategies 2, Afrika Kesho, by Karabo Manasoe

In my last article, Introduction to investing strategies #1, I talked about the growth investing strategy and the value investing strategy – today, it’s dividend investing and momentum investing.

Before I dive in, let me explain what a dividend is.

A dividend is money paid to someone who owns shares in a company, for simply owning those shares. You can think of a dividend as a form of “thank you” for the money and trust you put in the company you own shares in. This is because as an investor in a company, you own part of the company and so you put your trust in the people who run the company to make good use of your money and grow your investment. This trust in the company and the risk of losing some of your money if the company’s share price goes down is rewarded in the form of a dividend payment.

Dividends are paid from the company’s profits, and not all companies pay dividends – it’s up to the management of the company whether the company pays dividends or not. If the profits of the company would be better off being reinvested in the company, like is the case with most small companies, the management chooses not to pay dividends.

Regardless of your investment strategy, if a company you have shares in declares that they are going to pay dividends, you will receive your payment.

The Dividend Investing Strategy

What it is

The focus of the dividend investing strategy is on, guess what, dividends. As a dividend investor, you look for quality companies that have good dividend pay-out policies. By choosing only companies that reliably pay dividends, you create a source passive income for yourself. This is on top of the money you earn when the value of the shares you own goes up. This income source can grow to be substantial over the long term, and you can get to a point where you can live off your dividends.

The investor who uses the dividend investing strategy has two options when looking for quality companies:

  1. They can either put their money in companies that are mature, and so are in a good financial position to pay dividends consistently, or
  2. They can put their money in companies that are paying out small dividend amounts in the short-term, because they believe that the dividend amounts will grow in the long term, because the company has the potential to grow.

The second approach (2.) above is often called the dividend growth investing strategy. It can be thought of as a modification of the first approach (1.).

Dividend Investing

Personality of a dividend investor

As a dividend investor you must have patience. As the size of your investments grow over the long term, either from you investing more of your income or by you reinvesting the dividends you earn, you will receive bigger and bigger dividends. This is because the more shares you have in a company, the more dividends you get from that company.

Another quality you have is that you seek safety and security – you are “boring”. Since the focus of dividend investing is mature companies – usually old and stable companies that may not be trending on the news or social media – you must make peace with the fact that your investments will have a lot of safe and secure companies. Although the rule of owning mature companies is not set in stone, you should be able to make peace with the possibility.

The process used in dividend investing

Intuitively, the approach of dividend investing is, “Let me just see which companies pay out dividends and invest in them,” but the process is more involved than that. You want to pick a company that pays dividends, but you also want to know other things about the company besides its dividends. You want to know:

  • the performance of the company
  • how the company finances its dividend pay-outs
  • whether the dividend payments have been consistent or not
  • how much debt the company has, amongst other things

These are all important in your investment decision.

Risks of dividend investing

When using the dividend investing as a strategy, the main risk is that the company can choose not to make a dividend payment. There are several reasons the company could do this, but the decision does lie with them.

Another risk is called interest rate risk. In this case the investor asks: “Can I put my money in a low-risk savings account at a bank or do I risk my money in hopes of earning a higher dividend rate than the interest rate offered at a bank?” If the dividend payment rate is lower than the interest rate offered at a bank, then the investor is better off putting their money in a savings account to minimize risk.

The Momentum Investing Strategy

What it is

The momentum investing strategy is based on a concept called a trend. Just like the clothing trends and social media trends we see in our daily life, share prices can also trend. With clothing trends, for example, we know that in summer, shorts and sleeveless shirts may trend. Whereas in winter, it is usually jackets and socks that trend. Trends also exist in the world of companies.

In the world of companies, when there are more people buying a company’s shares than there are people selling, then the share price of a company increases. This is what we call a positively trending share price. It also works vice versa and is called a negatively trending share price. The momentum investor uses these trends to decide where to invest to make a profit.

The momentum investor believes in these words: “When the price of a company’s stock has been going up for a certain amount of time in the past, it is likely to going up in the future.”

The amount of time the stock will continue to go up in the future is unknown. A trend can last for a few days, months or even years. The momentum investor will simply stay invested until the company stock stops trending.

Momentum Investing

Personality of a momentum investor

The most important quality of a momentum investor is discipline. The momentum investing strategy is based on rules. The investor must set up rules that tell them which stocks to buy, and when to sell; and these rules must be followed religiously. Without discipline, this investment strategy would be an incorrect one to follow. The great thing about discipline is that a person can learn to be disciplined, as I once had to learn when I started investing.

A momentum investor should also be dynamic and aware. Since the investor does not know how long a trend will continue, they must be dynamic enough to change their mind should things not go their way and the trend stops. The investor should also be aware of herd behaviour and not go against the flow of the herd. Herd behaviour is when everyone is buying or selling the same stocks. The reason for this awareness of herd behaviour is that the herd is the one that causes the trending of different stocks, and going against the herd would mean not following the momentum investing strategy.

The process used in momentum investing

For momentum investing, you would use Technical AnalysisThis is a method of evaluating your investments and identifying trading opportunities using price trends and chart patterns. This is used because momentum investing is rules-based.

When you are a momentum investor, you look for shares prices that are increasing regularly and invest in them. When they stop increasing regularly, they have lost momentum, so you sell them and take your profits.

Risks of momentum investing

The main risk of momentum investing is the famous line: “Please remember that past performance may not be indicative of future results.” This means that just because a share price has been increasing recently, it does not mean that it will continue increasing. Since momentum investing depends on past performance to make predictions about a stock’s performance, you should be careful because past performance may not continue.

Sometimes, a momentum investor buys a stock that they believe is trending in a certain direction and the trend actually goes in the opposite direction that the investor predicted. This could result in losses for the investor.

In a nutshell…

That completes the introduction to both dividend investing and momentum investing. In my next article, “An introduction to Investing Strategies #3,” I will be discussing Sector Specific Investing and Factor Investing.

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This article was written by Karabo Manasoe.

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