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3.7: Stock Investment Strategies

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    Video - Audio - YouTube

    In our last section, we will discuss various stock strategies. Some go so far as to call these strategies investment philosophies, sets of beliefs and principles that guide investors’ decision-making processes. That may sound a bit far-fetched to many. Should investing be likened to a philosophy or religion? Maybe not, but it is true that without sufficient education and a well thought out strategy beforehand, investing in stocks can be difficult and very challenging. There is an old saying in the industry attributed to George Goodman, who wrote under the pen name Adam Smith: “If you don’t know who you are, [the stock market] is an expensive place to find out.” Let’s see which of the following stock investing strategies will help you find out who you are without having to pay a princely sum.

    Buy and Hold Strategy

    The most common strategy for prudent, long-term oriented investors is called the buy and hold strategy. Buy and hold investors use research and analysis to identify high-quality companies with good growth prospects and potential for dividends at reasonable prices and hold them for the long term. It is also referred to at times as value investing or growth at a reasonable price (GARP) investing. How long should one hold onto their stock investments? The renowned investor Warren Buffett was once asked what Berkshire Hathaway’s favorite holding period was. He famously quipped, “Our favorite holding period is forever.

    Let’s revisit the wisdom of Jack Bogle, Founder and former CEO of the Vanguard Funds:

    “An investor is a person who owns business and holds it forever and enjoys the returns that U.S. businesses, and to some extent global businesses, have earned since the beginning of time. They have capital, they earn a return on their capital and that capital grows over time. It’s not complicated. That’s the business of investing.” ‒ John “Jack” Bogle, Founder and former CEO of the Vanguard Group

    Obviously, Mr. Buffett and Mr. Bogle are engaging in a bit of mischief because no one lives forever. However, their advice makes sense. If you owned a shoe shop or a pizza restaurant, you would not sell it just because the price went up or down 10%. You would hold onto your business. When the time comes, you may decide to sell it and retire. You may also decide to hand it over to your heirs or ultimately bequeath it to them. But as long as the business is sound, you would want to hold on to it. The same can be true for your stock investments. They are businesses, after all. Don’t lose perspective.

    Income Strategy, aka Equity Income

    A strategy that fits well with the buy and hold strategy is the income strategy, also known as the equity income strategy. Do you recall the equity income category of stock mutual funds from our previous chapter? Income oriented stock investors emphasize dividends over capital appreciation. Ideally, investors are seeking companies with rising earnings that will support rising dividends. Companies that pay consistently growing dividends tend to do well when the market as a whole does poorly and have been some of the best long-term investments. In general, this strategy is appropriate for conservative stock investors and works very well with Dividend Reinvestment Plans (DRIPs). Investors using the income strategy resemble the tortoise in the fabled race between the tortoise and the hare.

    Growth Strategy

    The growth strategy involves investing in stocks with above-average forecasts of earnings growth. Dividends are a secondary concern since growing companies usually need to use their earnings to reinvest and grow the business. As discussed, the stocks of these companies usually have high price to earnings ratios in expectation of higher earnings in the future. A growth-oriented investor should be prepared for a great deal of volatility. However, if the investor researches, chooses, and subsequently monitors their investments carefully ‒ and does not panic when the markets fall! ‒ a growth strategy can be very profitable in the long term.

    A well-respected group that advocates the growth investing strategy is the National Association of Investors Corporation (NAIC), now known as BetterInvesting.org. They have been in existence since 1951. BetterInvesting.org sponsors investment clubs which are groups of investors who are dedicating to educating themselves about investments while pooling their resources and collectively investing a portfolio of stocks. The investment clubs use a time-tested tool called the Stock Selection Guide (SSG). BetterInvesting.org says that their goal is to achieve a 15% annual rate of return. Joining an investment club is an excellent way to learn while you earn. We discuss BetterInvesting.org and the Stock Selection Guide in Addendum A.

    Aggressive Growth Strategy

    The aggressive growth strategy entails much speculation and short-term trading. An aggressive growth investor aggressively trades in and out of stocks in order to achieve eye-catching returns. They don’t really ever want to own a stock; they are simply renting the stock. Instead of waiting 3 to 5 years for a stock to move, an aggressive stock trader would go after the same investment return in 6 months to a year or less. Some traders have time horizons in the weeks or days or hours or minutes. Recall that there are High Frequency Trading (HFT) companies who are using computers to make millions of trades per day. Aggressive growth investors somehow believe that they can outsmart and outgun these HFT firms.

    The aggressive growth strategy is the strategy that many people think they are supposed to use when they start investing in stocks. They see images of traders behind four screens talking on two telephones at the same time and gesturing wildly with their colleagues. They believe they need to do the same. We refer you again to the phrase, “The Loser’s Game,” coined by the excellent investment author Charles “Charley” Ellis. Aggressive growth investing is fraught with perils and drawbacks, not the least of which are the serious transaction costs that can be generated as a result of frequent trading. Stockbrokers simply adore suckers, ooops!, uh, we mean speculators and traders who use this strategy.

    Just in case you have not noticed, Your Humble Author sincerely hopes that you don’t attempt this strategy. Remember, if you don’t know who you are, the stock market is a very expensive place to learn. And if we haven’t convinced you yet about the dangers of short-term trading, please take a look at the following graph.

    Month-to-month gyrations of the MSCI World index. In the short term, stock movements appear random. Trying to predict what the next month will bring is futile.

    These are the month-to-month percentage returns of the MSCI World index from 1991 to 2000. In the short term, stock movements appear random. Trying to predict what the next month will bring is futile. Let’s now look at the same time period, except in this graph, we see the year-to-year results of a hypothetical $10,000 investment.

    This is the same time period except we see the results from year to year. Keep a long-term perspective, Dear Readers.

    Source: The Capital Group

    Contrarian Strategy

    The contrarian strategy is a strategy that merits our attention, even though few of us will have the will to follow it unerringly. Contrarian investors invest in stocks that are out of favor with the market for some reason, as reflected by low price to earnings ratios and low prices compared to their fundamentals. It involves actively seeking stocks from companies with sound financial statements that the market has undervalued. A famed contrarian investor quipped, “I always try to be accommodating. I buy when others want to sell; I sell when others want to buy.” Of course, this is easier said than done. Historically, the market goes up three or four years for every one year that it goes down. If you are always selling when others are buying, fairly soon, you won’t have any stocks to sell. Likewise, one must wait until there is panic in the markets before stepping up to the plate and buying with abandon. When asked what it was like to be a contrarian investor, Howard Marks, CEO of Oaktree Capital, said, “[It’s] not a steady business.”

    An example of a master contrarian investor in action was Warren Buffett in the mid-2000’s. As the prices of stocks and, more ominously, real estate rose to nosebleed valuation, Mr. Buffett patiently sat on his hands and waited. In the Fall of 2008 as the wheels fell off the economy because of the real estate bubble bursting, Mr. Buffett penned an opinion piece in the New York Times. In his opinion piece, he encouraged his fellow countrymen and countrywomen to, “Buy American. I Am.” Did Mr. Buffett follow through on his own advice? Yes, he did. He swooped in and bought $5 billion worth of General Electric and Goldman Sachs. He then subsequently invested $10 billion in Bank of America. All three purchases proved immensely profitable.

    Long-term buy and hold investors can take a tip from contrarian investors. Typically buy and hold investors invest systematically, in good times and bad. However, when the organic matter hits the ventilating device and there is panic in the streets, prudent, long-term oriented investors can accelerate their investment program and purchase more than they normally would, assuming additional funds are available. They can then proudly state that they have something in common with the likes of Warren Buffett, even if that something in common is not the size of their investment portfolios.

    Sector Rotation, Momentum Trading, and Market Timing Strategies

    The last three strategies we will title, Tweedledumb, Tweedledumber, and Tweedledumbest, although their order is entirely up to you. Sector rotation involves buying stocks in the current "hot" sectors of the economy and selling those stocks in the stale ones. An investor attempting to utilize this strategy must determine which methods they will use to decide which sectors are hot and which are not and if and when those sectors will reverse themselves. Typically, the neophyte will choose a hot sector just as it is beginning to cool and turn downwards. Of course, they will stubbornly hold onto it just long enough for it to hit bottom. That is when they finally give up on the sector and move to another hot sector just in time for the first sector to start gaining and the second sector to start losing. If it were not for the fact that the unfortunate individual is losing real money, it would be comical.

    Momentum trading is very similar to the aggressive growth strategy. The momentum trader buys stocks as they go up and sells stocks as they go down, often utilizing trading techniques that profit when stock prices go down. This is sometimes called the “Greater Fool” Theory. Momentum traders say to themselves, "Hey, it’s okay if I buy high because somewhere out there is a greater fool than I am so I will be able to sell higher." This theory was utilized by far too many uninformed speculators in the dot-com bubble of the late 1990’s and in the housing market mania of the mid-2000’s with the subsequent Global Financial Crisis being the end result. Many market historians are saying that cryptocurrencies and NFTs (Non-Fungible Tokens) are exhibiting similar trends to what happened in the late 1990's and the mid-2000's but the similarities and analogies from one mania to the next are never perfect. In any event, whenever markets are moving higher or moving lower, the momentum traders will be there, attempting to realize short-term gains on the movement of the markets. We wish them well. They will need it.

    The market timing strategy involves attempting to predict the future directions of the market. The hardest part of market timing is that you must be correct twice. You must time the fall and then time the subsequent rise of the market. Just picking one would be a Herculean feat! The famed mid-20th Century investor Bernard Baruch said, “Don’t try to buy at the bottom and sell at the top. This can’t be done … except by liars.”

    Obviously, which choice you make is up to you as it is your money that will be invested. However, Your Humble Author hopes that you will see that for the vast majority of us the aggressive growth, sector rotation, momentum, and market timing strategies should be avoided at all costs. Being a growth or contrarian investor is not easy but should be rewarding if executed well. The buy and hold and income strategies are the easiest to implement, not the least of which is because they help us to tame our emotions when we are confronted with adverse markets.


    This page titled 3.7: Stock Investment Strategies is shared under a CC BY-NC-SA 4.0 license and was authored, remixed, and/or curated by Frank Paiano.