November 2, 2024

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5 Key Investment Strategies to Learn Before Trading

5 Key Investment Strategies to Learn Before Trading

An investment strategy is a set of principles that guides your investment decisions. With seemingly countless theories and approaches on offer, from simplistic learn-this-one-trick pop investing books to dense tomes by financial doctorates filled with statistical tests of long-term financial data, it’s easy to feel overwhelmed and uncertain about where to start. However, by focusing on a few key investment strategies, even beginning traders can lay a solid foundation for long-term success in the market.

Before trading, it’s crucial to understand the fundamental principles and techniques that have stood the test of time. When properly applied, these strategies have helped many investors manage risks and maximize their returns. Whether you’re aiming to build a balanced portfolio, capitalize on market trends, or generate steady income, having a grasp of these trading essentials is vital.

Below, we’ll explore five key investment strategies that every aspiring trader should learn before entering the market. From value and growth investing to dollar-cost averaging, we’ll break down the core principles and advantages of each, giving you a clear understanding of how they work and when to apply them.

Key Takeaways

  • Before choosing a stock market strategy, thoroughly assess your financial situation, risk tolerance, and investment goals. This self-awareness should be the basis of any approach you take.
  • Passive index investing involves putting your money into index-tracking mutual or exchange-traded funds (ETFs), offering built-in diversification and a hands-off approach.
  • Investors who follow growth strategies should review the executive teams of the firms they’re investing in and news about the economy and relevant sectors.
  • Momentum investors buy stocks trending upward and short sell them since they view them as likely to come back down to earth.
  • Dollar-cost averaging removes the pressure of trying to time the market perfectly. It’s a disciplined approach that involves investing consistently over time, regardless of market fluctuations.

Getting Started

Before choosing an investment strategy, it’s important to gather some basic information about your finances. Let’s get you started with these important strategic questions:

Strategic Question 1: How Are Your Finances?

Even though you don’t need much money to start, you shouldn’t begin investing until you can afford to do so. If you have debts or other obligations, consider the impact investing will have on your short-term cash flow before you start putting money into your portfolio.

Most advisors recommend paying down your debts and having a three-to-six-month emergency fund before socking significant amounts into an investment portfolio. As you build toward getting ready to trade, you should sort out how much you can afford to put into your stock market account.

Strategic Question 2: What Are Your Financial Goals?

Next, set out your objectives. Everyone has different needs, so you should determine yours. Are you saving for retirement? Are you looking to make big purchases like a home or car? Are you saving for your or your children’s education? Answering these questions will help you narrow down a strategy since each approach requires different levels of liquidity, opportunities, and risk.

Ensure you can afford to invest before you start putting money away. Prioritize paying off high-interest debt, for example, before setting money aside for the future.

Strategic Question 3: What Is Your Risk Tolerance?

Next, figure out your risk tolerance. This is determined by answers that can be put into numbers and some that can’t. First, there’s your age, income, and how long you have until retirement. Investors who are younger have time on their side to recuperate losses, so it’s often recommended that younger investors hold more risk than those who are older.

Your risk tolerance is also highly psychological and deeply personal. People who grew up in the same home and have very similar experiences and income can have very different reactions to specific financial situations. How would you feel if your investments dropped 30% overnight? How would you react if your portfolio is worth $1,000 less today than yesterday? Sometimes, the best strategy for making money could make you deeply uncomfortable. Your investment strategy will need to align with where your comfort level ultimately is.

Strategic Question 4: Can You Handle Market Volatility?

Relatedly, you’ll need to be able to handle the ups and downs of the market. Alyson Claire Basso, a managing principal of Hayden Wealth Management in Middleton, Massachusetts, told us she makes it a point with her clients “to discuss past market experiences and potential future market volatility. This way, they feel prepared and know that volatility is something we’ve planned for.” This discipline is important when thinking about investment strategies. “We talk about their financial goals and how sticking to their plan can help them ride out the rough patches. I also remind them that diversified investing helps spread out risk, so they’re not putting all their eggs in one basket.”

Once you’ve answered the strategic questions above, you’ll want to learn the basics of investing: how to read stock charts, etc., and then begin picking some of your favorite companies and analyzing their financial statements. You’ll also need to keep up to date with recent news about industries you’re interested in investing in. It’s a good idea to have a basic understanding of what you’re getting into so you’re not investing mindlessly.

Risk isn’t necessarily bad in investing. Higher-risk investments are often rewarded with higher returns. “A holistic financial plan balances threats, opportunities, risks, and rewards,” said Neil R. Waxman, a managing director of Capital Advisors in Shaker Heights, Ohio. Waxman emphasized the importance of understanding how risks and rewards can be balanced while providing cash flow to those who need it. “A client who understands these connections and has a clear game plan” will have “the perspective and vision needed to be a patient investor.”

Strategy 1: Passive Index Investing

Passive index investing has gained significant popularity since the introduction of passive index-based mutual funds in the 1970s and then similar ETFs in 1993. Unlike actively managed funds, where an individual or team makes decisions on the underlying assets in an attempt to beat the market, passive mutual funds and ETFs track an index like the S&P 500; they don’t work to beat the market so much as match it.

Since the S&P 500, an index of the 500 largest publicly traded American companies, has been up over time, this has been a winning strategy for many investors. Below is a chart of the percentage of large-cap domestic equity funds that have underperformed the S&P 500 since 2001:

In addition, the hands-off approach means fund managers charge lower fees given the less work required vs. active management. The passive investing strategy has the benefit of lower turnover. When assets move in and out of the fund at a slower pace, it results in fewer transaction costs and realized capital gains, which can lead to potential savings when tax filing season arrives.

Pros and Cons of Passive Index Investing

Pros

  • Lower costs because of minimal trading, research, and management fees

  • Simplicity and ease of implementation through passive funds

  • Broad diversification across multiple sectors

  • Potential for long-term growth in line with the market

  • Greater flexibility for investors to execute a buy-and-hold strategy

Cons

  • Can’t outperform the market

  • Exposure to market downturns and volatility

  • Missed opportunities in specific sectors or regions

  • Reliance on the performance of the underlying index or sector

  • Potential for tracking errors (lack of a perfect match in performance) between the fund and the underlying index

Who Benefits From Passive Index Investing

Passive index investing can be a great choice for beginner investors starting to explore the stock market. It’s an ideal entry point for those who may feel overwhelmed by the complexity of the financial markets. Investing in index funds or ETFs that track broad market indexes allows you to gain exposure to a diverse range of companies and sectors without the need for extensive research or stock-picking skills.

But this isn’t just a rookie move: experienced investors also invest heavily in such funds, which now make up about half of all volume traded in mutual and exchange-traded funds combined. Long-term investors benefit greatly from passive index investing, particularly those saving for retirement or other distant goals. The buy-and-hold nature of passive index investing allows investors to ride out short-term market fluctuations and benefit from the power of compound growth over time. In addition, the lower fees of passive investing can lead to significant savings over time.

Strategy 2: Value Investing

Pros and Cons of Value Investing

Pros

  • There’s long-term opportunity for large gains as market prices meet up with a company’s true intrinsic value.

  • Value companies often have stronger risk/reward relationships.

  • Value investing is rooted in fundamental analysis and supported by financial metrics.

  • Value companies are more likely to issue dividends as they aren’t as reliant on cash for growth.

Cons

  • Value companies are often hard to find.

  • Successful value investments take time, and investors must be more patient.

  • Even after holding long-term, there’s no guarantee of success since the company may even be in worse shape than before.

  • Investing only in sectors that are underperforming decreases your portfolio’s diversification.

Value investors are your bargain shoppers of the investing world. They look for stocks with prices they believe don’t reflect the security’s intrinsic value. Value investing is premised, in part, on the idea that some degree of irrationality exists in the market. This irrationality, in theory, presents prospects to get a stock at a discounted price and make money from it.

It’s not necessary for value investors to comb through volumes of financial data to find deals. Thousands of value mutual funds and exchange-traded funds (ETFs) offer shares in baskets of stocks thought to be undervalued. For example, the Russell 1000 Value Index is a popular benchmark for value investors, and several mutual funds track this index.

For those who don’t have time to perform exhaustive research, the price-earnings ratio (P/E) is an often-used measure for quickly identifying undervalued or cheap stocks. The metric derives from dividing a stock’s share price by its earnings per share (EPS). Value investors seek companies with a low P/E ratio; a lower P/E ratio means you’re paying less per $1 of current earnings.

For a nuanced guide to using the P/E ratio to evaluate stocks, see Investopedia’s Are Stocks With Low P/E Ratios Always Better?

Who Benefits From Value Investing

Value investing is best for investors looking to hold their securities long-term. If you’re investing in value companies, it may take years (or longer) for the businesses to scale up. Value investing focuses on the big picture and often attempts to approach investing with a gradual growth mindset.

People often cite legendary investor Warren Buffett, who sees himself as the epitome of a value investor. Consider Buffett’s words when he made a substantial investment in the airline industry. He explained that airlines “had a bad first century.” Then he said, “And they got that century out of the way, I hope.” This illustrates much of the value investing approach: choices are based on decades of trends and with decades of future performance in mind.

A rich set of academic studies has found that value investing can produce superior returns over the long term. However, value investing has had periods where it has underperformed growth investing, especially when tech stocks have posted outsized price gains.

Strategy 3: Growth Investing

Pros and Cons of Growth Investing

Pros

  • Growth stocks and funds aim for shorter-term capital appreciation. If you make profits, it’ll usually be quicker than value stocks.

  • Once growth companies begin to grow, they often experience the sharpest and greatest stock price increases.

  • Growth investing doesn’t rely as heavily on fundamental analysis and can be easier to begin investing in.

  • Growth companies can often be boosted by momentum; once growth begins, future periods of continued growth (and stock appreciation) are more likely.

Cons

  • Growth stocks are often more volatile. Good times are good, but if a company isn’t growing, its stock price will suffer.

  • Depending on macroeconomic conditions, growth stocks may be long-term holds. For example, increasing interest rates works against growth companies.

  • Growth companies rely on capital for expansion, so don’t expect dividends in the short term.

  • Growth companies often trade at high multiples of earnings; entry into growth stocks may be higher than entry into other types of stocks.

Rather than look for low-cost deals, growth investors want investments that offer strong upside potential for future earnings. It could be said that a growth investor is often looking for the “next big thing.” However, this strategy isn’t a reckless embrace of speculative investing. Instead, it involves evaluating a company’s health and potential to grow.

A drawback to growth investing is a lack of dividends. When a company is growing, it often needs capital to sustain its expansion. This doesn’t leave much (or any) cash left for dividends. Moreover, with faster earnings growth comes higher valuations, which are, for most investors, a higher risk proposition.

While there is no definitive list of hard metrics to guide a growth strategy, there are a few factors an investor should consider. Growth stocks tend to do comparatively well during periods of falling interest rates, as newer companies find it less expensive to borrow to fuel their expansion. It’s essential to keep in mind, however, that at the first sign of a downturn in the economy, growth stocks are often the first to get hit.

Growth investors also need to carefully consider the management of a business’s executive team. Achieving growth is among the most difficult challenges for a firm. Therefore, a stellar leadership team is required. You’ll also need to evaluate the competition. A company may enjoy stellar growth, but if its primary product is easily replicated, the long-term prospects are dim.

Who Benefits From Growth Investing

Growth investing is inherently riskier and generally only thrives during certain economic conditions. Investors looking for shorter investing horizons with greater potential than value companies are best suited for growth investing. Growth investing is also ideal for investors not concerned with investment cash flow or dividends.

According to a study from New York University’s Stern School of Business, “While growth investing underperforms value investing, especially over long periods, it is also true that there are sub-periods, where growth investing dominates.” The challenge, of course, is determining if these “sub-periods” are occurring. While trying to time the market is often unwise, growth investing is most suitable for investors who believe strong market conditions lie ahead.

Because growth companies are generally smaller and younger with less market presence, they are more likely to go bankrupt than value companies. It could be that growth investing is better for investors with higher disposable income as there is more downside for the loss of capital than other investing strategies.

Strategy 4: Momentum Investing

Pros and Cons of Momentum Trading

Pros

  • Higher risk means higher reward, and there’s greater potential short-term gains using momentum trading.

  • Momentum trading is done in the short term, and there’s no need to tie up capital for long periods of time.

  • This style of trading can be seen as simpler as it doesn’t rely on bigger picture elements.

  • Momentum trading is often the most exciting style of trading. With quick price action changes, it is a much more engaging style than strategies that require holding securities long term.

Cons

  • Momentum trading requires a high degree of skill to properly gauge entry and exit points.

  • Momentum trading relies on market volatility; without prices quickly rising or dropping, there may not be suitable trades to be had.

  • Depending on your investment vehicles, there’s increased risk for short-term capital gains.

  • Losses can happen very quickly; without notice, an entry and exit point may no longer exist and you’re stuck with the losses coming your way.

Momentum investors ride the wave. They believe winners keep winning and losers keep losing. They look to buy stocks experiencing an uptrend. Because they believe losers continue to drop, they may choose to short sell these securities.

Momentum investors are heavily reliant on technical analysis. They use a strictly data-driven approach to trading and look for patterns in stock prices to guide their purchasing decisions. This adds weight to how a security has been trading in the short term.

Momentum investors act in defiance of the efficient-market hypothesis, which states that asset prices fully reflect all information available to the public. A momentum investor believes that given all the publicly disclosed information, there are still material short-term price moves that can be taken advantage of. Despite some shortcomings, momentum investing has its appeal. Consider, for example, the MSCI World Momentum Index, which has averaged annual gains of 10.75% since its inception in 1994 through June 2022, compared with 7.59% for its benchmark over the same period.

Who Benefits From Momentum Investing?

Traders who adhere to a momentum strategy must always be at the switch and ready to buy and sell. Profits build over months, not years. This contrasts simple buy-and-hold strategies that take a “set it and forget it” approach.

In addition to being heavily active with trading, momentum investing often calls for a skilled ability to use technical analysis. Momentum investing relies on data for proper entry and exit points, and these points are continually changing based on market sentiment. For those with little interest in watching the market closely there are momentum-style ETFs.

Strategy 5: Dollar-Cost Averaging

Pros and Cons of Dollar Cost Averaging

Pros

  • DCA can be combined with the other strategies mentioned above.

  • During periods of declining prices, your average cost basis will decrease, increasing potential future gains.

  • DCA removes the emotional element of investing, requiring reoccurring investments regardless of how the markets are doing.

  • Once set up, DCA can be incredibly passive and require minimal maintenance.

Cons

  • DCA can be difficult to automate especially if you are not familiar with your broker’s platform.

  • During periods of declining prices, your average cost basis will decrease, increasing your future tax liability.

  • You must have steady, stable cash flow to invest to DCA.

  • Investors may be tempted not to monitor DCA accounts; however, investments—even automated ones—should be reviewed periodically.

Dollar-cost averaging (DCA) is when you make regular investments over time, as when you set aside part of your paycheck for your 401(k). It can be and often is used with the other strategies above. However, the point of this is discipline: even if the market is going down or you’re most worried about investing, you still put away a set amount periodically. This means you benefit when stocks are low and you can buy more with the same amount of funds.

This disciplined approach becomes particularly powerful when you use automated features that invest for you. The benefit of the DCA strategy is that it avoids the market timing strategy, which can be painful and ill-fated for many people. Even seasoned investors occasionally feel the temptation to buy when they think prices are low, only to discover that their market timing was wrong.

When investments happen in regular increments, you capture prices at all levels, from high to low. These periodic investments effectively lower the average per-share cost of the purchases and cut the potential taxable basis when you sell later on.

Who Benefits From Dollar-Cost Averaging?

DCA is a wise choice for most investors. It keeps you committed to saving while reducing the level of risk and the effects of volatility. Most investors are not in a position to make a single, large investment. A DCA approach is an effective countermeasure to the cognitive bias inherent to humans. New and experienced investors alike are susceptible to hard-wired flaws in judgment.

Loss aversion bias, for example, causes us to view the gain or loss of an amount of money asymmetrically. In addition, confirmation bias leads us to focus on and remember information that confirms our long-held beliefs while ignoring contradictory information that may be important. DCA circumvents these common problems by removing human frailties from the equation.

You must have ongoing cash flow and reoccurring disposable income for a workable DCA strategy. Many online brokers have options to set up reoccurring deposits. You can adjust them based on changes in your personal cash flow or investment preference.

You’ve Picked Your Stategy, Now What?

Suppose you’ve narrowed down a strategy; great! There are still a few things you’ll need to do before you make the first deposit into your investment account. First, figure out how much money you need to start investing. This includes your upfront investment and how much you can continue investing.

You’ll also need to decide on the best way for you to invest. Do you intend to go to a traditional financial advisor or broker, or is a passive, worry-free approach better for you? If you choose the latter, consider signing up with a robo-advisor.

Consider your investment vehicles. Cash accounts can be immediately withdrawn but often have the greatest consequences. Accounts like 401ks can’t be touched until you retire without fees and have more limited options, but your company may match your investment. Different types of IRAs also have various levels of flexibility.

It also pays to diversify. To reduce the risk of one type of asset bringing down your entire portfolio, consider spreading your investments across stocks, bonds, mutual funds, ETFs, and alternative assets. If you’re socially conscious, you may consider responsible investing. Now is the time to figure out what you want your investment portfolio to be made of and what it will look like.

How Do I Set Up an Investment Strategy?

A general investment strategy is formed based on your long-term goals. How much are you trying to save? What is your timeline for saving? What are you trying to achieve? Once you have your financial goals in place, you can set target performance on returns and savings, then find assets that mesh with that plan.

For example, your goal may be to save $1 million. To reach this, you need to invest $10,000 per year for 29 years and achieve 8% annual returns. Armed with this information, you can analyze various historical investment performances to try and find an asset class that achieves your strategic target.

What Is Warren Buffett’s Investment Strategy?

Warren Buffett has long been widely regarded as among the world’s most skilled and successful investors. Warren Buffett’s investing strategy is based on the principles of value investing. He focuses on identifying undervalued companies with strong fundamentals, consistent earnings, and competitive advantages (which he calls “economic moats”). Buffett believes in long-term investing, holding stocks for many years or even decades. He also emphasizes the importance of understanding the businesses he invests in and only investing within his “circle of competence.” Lastly, Buffett prefers companies with strong management teams, low debt, and the ability to generate high returns on invested capital.

How Does Risk Tolerance Affect an Investment Strategy?

Risk tolerance is the amount of risk that an investor is willing to endure. It plays a significant role in determining the type of investment strategy that someone chooses and how much they opt to invest. Investors with longer time horizons might be more willing to take on a riskier investment, while investors focused on a short-term financial goal might be more risk-averse.

What Is the Safest Investment Strategy for Earning High Returns?

There’s always a risk-return trade-off. In other words, the safer your investments are, the lower the expected returns over time (and vice versa). That said, there are ways to maximize investment returns while minimizing risk. One effective approach is to create a well-diversified portfolio across various asset classes, such as stocks, bonds, real estate, and commodities.

By spreading your investments across different sectors and industries, you can cut the impact of any single investment’s performance on your overall portfolio. This helps to mitigate unsystematic risk, which is the risk associated with individual companies or sectors. A good way to follow this strategy is to use low-cost index funds or ETFs and follow the model of modern portfolio theory. This provides for a passive long-term portfolio that maximizes return for a given level of risk.

What Is the Least-Risky Thing to Invest In?

Cash is, by definition, the lowest-risk asset since it cannot incur a loss ($1 always = $1), but it will lose purchasing power because of inflation over time. U.S. Treasurys are also considered one of the safest investments, as they are backed by the full faith and credit of the U.S. government. Treasurys have various maturities, ranging from short-term Treasury bills (T-bills) to longer-term Treasury notes and bonds.

While Treasurys are generally considered risk-free in terms of default risk, they are still subject to interest rate risk. When interest rates rise, the value of existing bonds declines, as newer bonds are issued with higher yields.

The Bottom Line

How you choose your strategy may be more important than the strategy itself. Indeed, any of these strategies can generate a significant return if the investor makes a choice and commits to it. It is essential to choose because the sooner you start, the greater the effects of compounding.

Remember, don’t focus exclusively on annual returns when choosing a strategy. Take the approach that suits your goals, income, and risk tolerance. With a plan in place and your goals set, you’ll be on a prudent long-term investment journey.

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