Find the Investing Style That's Right for You

By Andrea Cannon on 5 January 2016 0 comments

No matter how carefully you invest, there will always be some level of risk involved. But by choosing an investing style that works for your risk/reward preferences, age, and investment timeline, you can help manage how well your investment portfolio will perform.

We've created this primer on investing strategies to help you better understand which investing style may be right for you.

Active vs. Passive

How determined are you to outperform the market? This will help you answer the question of whether you prefer an active vs. passive investment strategy.

Active

An active investor generally wants to exceed the performance of a benchmark index (such as the S&P 500). They're typically more aggressive and willing to accept more risk for potential greater reward.

Thus, they either trade more frequently, or choose to invest in actively managed funds featuring portfolio managers who are consistently trading and working to increase investor returns. This means that actively managed funds typically charge higher fees than passively managed funds, since the costs of more frequent trades, staff, and other needs add up. Keep in mind, however, that research indicates few active traders or fund managers beat the market consistently.

Passive

A passive investor is typically less concerned about outperforming the market. Instead, they simply want to achieve returns that match their benchmark index. Why would anyone not try to beat the market, you might ask? For starters, it's nearly impossible to do so on a consistent basis, which means your returns might suffer. And active investing incurs more fees, further eroding the returns on your money.

For this reason, passively managed funds tend to be more affordable — they don't require a full-time team of researchers, nor are they placing frequent trades. Most experts suggest that for most investors, passive investing generates the greatest returns over time.

Growth vs. Value

Both growth and value investing strategies focus on choosing stocks that provide the best possible returns. However, their underlying philosophies and approaches differ significantly.

Growth

Growth investing focuses on companies with faster than average projected growth (better known as "growth stocks"). In most cases, these companies are growing very quickly and reinvesting most of their earnings back into the business to encourage continued future growth. They tend to have higher price-to-earnings ratios, making them more expensive than value stocks.

The benefit of investing in growth funds is they have a greater potential for higher returns, but consider that this also means that you are willing to accept more risk. This means that when stock prices are rising, you will likely do better than the overall market, and when stock prices are falling, you will likely do worse. But if you are willing to accept higher risk for potentially greater returns, than growth funds may be right for you.

Value

Value investing focuses on companies whose stock prices don't necessarily reflect their worth. There are a number of reasons why these stocks may be undervalued (such as negative publicity or lower-than-projected earnings), and you may be able to benefit from this. In order to find these types of funds, investors will look for a security that has been discounted so much that its market value is less than its intrinsic value.

Value funds tend to be safer than growth funds and generally have the potential for both current income (such as dividends) as well as long-term appreciation. These types of funds are ideal for risk-averse investors.

Blend

Blended funds invest in both growth and value stocks. This is ideal if you are willing to accept some risk and want to invest in growth companies, but also want to enjoy the lower price-to-earnings and price-to-growth ratios of value companies.

Market Capitalization Matters, Too

Have you ever wondered what the difference is between large value funds and small value funds? This has to do with market capitalization (or the size of the companies in which the fund invests). Market capitalization classes are defined as follows:

  • Large-cap companies have a total share value over $10 billion
     
  • Mid-cap companies have a total share value between $2 billion–$10 billion
     
  • Small-cap companies are those with a total share value under $2 billion

In most cases, more risk-averse investors will want to look for dependable large-cap stocks or stock funds, such as industrial stalwarts like Coca-Cola or IBM. Small-cap stocks or funds tend to have more risk, but also the potential for greater returns.

If you're still learning about investing, do your research. There are various online financial tools that can help you determine which investment strategy and types of funds are right for you. Most investing experts would agree that you should naturally reduce your investment risk tolerance as you age so that you aren't left with high risk investments right before retirement. Your needs — and investing style — may change over time, so re-assess your portfolio and investment style as your financial picture evolves. (See also: 8 Steps to Starting a Retirement Plan in Your 30s).

For more information and specific investment and asset allocation advice, consider consulting with a financial planner.

Do you have other tips for choosing the right investing style? Please share your thoughts in the comments!

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