Introduction to Investing Strategies #3

Introduction to Investing Strategies 3

In my previous publication, Introduction to Investing Strategies #2, the discussion was around the dividend investing and momentum investing strategies. Today’s article will discussion the buy-and-hold investment strategy and factor investing strategy.

Sector-specific investing is implicitly incorporated into every other investing strategy, so I will talk about the Buy-and-Hold strategy instead.

Now let’s get to today’s discussion.

Buy-and-hold Investing Strategy

What is it

The buy and hold investing strategy is based on the historical observation that stock markets perform better in the long run than any of the other asset classes, such as bonds and commodities. Believing this notion, the investor will select which stocks to buy and hold over a long period, usually years or decades. Even though the stock prices fluctuate, the investor will hold on to these stocks without worry.

Facts about the buy and hold investment strategy:

  • Because the investor does not actively manage and review their position in the market, this investment strategy is a passive strategy.
  • Also, because of the long time horizon the investor commits to when buying a stock, they will enjoy the other benefits of holding a stock for a long time, such as compounding, getting paid dividends, and the tax benefits that come with reinvesting one’s profits
  • One of the world’s most famous investor who uses the buy-and-hold strategy is Warren Buffet of Berkshire Hathaway

Personality of a buy-and-hold investor

As you might have guessed by now, the one important trait that the buy-and-hold investor must have is patience. To realize the benefits of this strategy, the investor’s time horizon for holding a stock must be at least 3 years.

Another personality trait that this type of investor needs to have is the ability to not be reactive. Often, the companies that the buy-and-hold investor has put money into will be in the news and trending. Unless the news is extremely bad for a particular company and requires the investor to think about selling their position quickly, all of this publicity is just “noise”. In the ears and eyes of the passive investor, the news and trends do not require any reaction.

Also, similar to a dividend investor who invests for the long term, the buy-and-hold investor is also boring. After all, there is not much excitement when using a passive approach. This hands-off approach, when implemented properly, reduces the stress that comes with investing.

The process used in buy-and-hold investing

The buy-and-hold investor is only actively involved in choosing their investments. After investing money into a particular company, they can have a hands-off approach. In order to determine which stock to buy, both technical and fundamental analysis may be used, separately or together.

Fundamental Analysis is implicitly made for evaluating long term investments, and thus is a good approach if the plan is to hold investments for a long time. When using technical analysis, however, you must use long-term technical analysis tools. This is also because the investments are meant to be held for a long time, and using short-term technical indicators will not do the investor any good, except in instances when they are trying to determine exactly at which price point to buy or sell an investment.

Risks of buy-and-hold

Although the buy-and-hold investor ignores small price fluctuations of a stock that they have invested in, sometimes ignoring these fluctuations may be detrimental. This is because in certain instances, such as liquidation, a stock will not have a temporary decline in the price but rather a long-term decline in the company’s stock price. This severe price drop may result in the investor losing all the profits they had gained from the company stock. The time it takes for the stock to recover from a decline in its price, and thus make the investor to break even, may be too long to be considered practical. In the worst-case scenario, the stock may not recover, and the investor will have to realize a loss by selling their stock.

One way to counter this risk of buy-and-hold investing is to periodically check on the stocks you invested in and sell them when they have a high probability of having a long-term price decline instead of a temporary one.

Factor Investing Strategy

The discussion around factor investing will take on a different format from all other investment strategies that I spoke about. I will exclude some of the points I made about the other investment strategies.

The basis of factor investing is the selection of securities – stocks, bonds, commodities, etc – that are associated with getting higher returns in the market and improve long-term risk and return ratio. In essence, the goal is to build a cost-effective portfolio that is also diversified.

The reason factor investing came into existence as an investment strategy is because it is believed that the other methods used to build portfolios are not well-diversified; when certain market conditions are present, you find that securities within a portfolio experience a decline all at one. This all-at-once-decline can be counteracted by a diversified portfolio, wherein the goal is to have individual securities that are not affected by the same external factors.

The two main factors that are used in factor investing are called macroeconomic factors and style factors.

By way of example, the style factors are as follows:

  • Value: emphasis is on securities that are priced at a discount to other similar securities. The belief is that discounted over the long-term, securities purchased at a higher price will result in higher returns (Similar to the value investing strategy)
  • Size: emphasis is selecting between small vs larger companies. The belief is that buying small companies generally yields better results because of the growth prospects of small companies. (Similar to some elements of the growth investing strategy)
  • Momentum: Does a stock have good momentum or not? If the security has performed well recently, then it is believed that this good performance will continue, and the security is purchased; positive momentum. Else, the security is sold because of recent bad performance; negative momentum. (Similar to the momentum investing strategy)
  • Volatility: emphasis is on the price fluctuation of different securities – some securities experience more erratic price fluctuations than other securities. The securities with minimal price fluctuations generally perform better than those with high price fluctuations.
  • Quality: emphasis is place on high-quality companies as opposed to those of a lesser quality. The high-quality stocks are believed to perform better than their counterparts of lesser quality.
  • Dividend Yield: Stocks with good dividend-payment policies are preferred to those that do not pay dividends. (Similar to the dividend investing strategy)

 

Examples of macroeconomic factors are as follows:

  • Growth
  • Inflation
  • Financial conditions (interest rates, currency performance etc.

 

Macroeconomics is a vast field of study, and so I won’t be discussing it in detail.

The key takeaway about factor investing is that it is not a standalone investment strategy, it incorporates other investment strategies, and it is also influenced by macroeconomic factors.

This article concludes the discussion on the introduction to investing strategies.

 

This article was written by Karabo Manasoe.

You can contact Karabo Manasoe by clicking on the social media buttons below, or by emailing him on: karabom@afrikakesho.co.za.

 

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