I’m sure you’ve seen poor interior design – a hodgepodge of items randomly selected and mashed together in one room. You should have seen the living room of my first townhouse. A total disaster. I’m now 38 years young and my wife has shown me the way: Almost all aspects of our home have been touched by a professional interior designer. Ahhhhh, much better.
Similarly, when an investor fails to meticulously design all aspects of an investment portfolio, he or she may end up with, well, a portfolio that looks like my first living room. While well intentioned, these portfolios typically fail mightily in terms of strategy and diversification, leaving the investor exposed.
In addition to aesthetics, I noticed something else when we used the interior designer. Not only were our rooms pleasing on the eyes, but the quality of the furniture was much improved. Plush pillows. Rich leather. Customized items to fit the space. Everything just felt better. Ultimate conclusion: Using a professional was absolutely worth it.
When you’re designing your investment portfolio, please don’t let it end up like my first living room. If you need help, consider including a financial advisor. If you’re intent on doing it on your own, consider the following approaches when constructing your overall design.
The simplest long-term investment strategy is buy and hold investing. In practice, this strategy works just like it sounds: You buy the security and hold it indefinitely. While this may sound remedial, it can be quite effective as investors are often their own worst enemies and sell their investments during emotional times (usually the wrong times). This approach removes that problem from the equation.
For buy and hold investors, it is a good idea to keep individual security positions small in terms of your overall portfolio. That way the picks you get wrong won’t do too much damage to your portfolio; on the other hand, the stocks that do very well will grow to be substantial positions over time.
Growth investing is a high-risk high-reward investment strategy. Companies in this category are usually still in their initial phase of growth and their stocks have the potential for substantial appreciation in price. When you invest in a growth company, these companies don’t pay their owners for being owners (in the form of a dividend). Instead, these companies typically reinvest capital in an effort to expand their footprint. The idea is that these companies will become larger and larger over time and hence more valuable. Growth stock owners are not rewarded by sharing in company profits, but instead by appreciation of the stock price. Of course, not all companies are successful.
Growth stocks typically have the highest valuations in the market. They need to live up to the market’s expectations to justify their valuations, or the stock price will correct – often very dramatically.
Value investors buy stocks trading at or below their fair value. This takes a considerable amount of skill as it relates to evaluating the fundamentals of a company, because, as with anything in life, a stock’s price is usually low for a reason. The key with value investing is to identify a company which the investor believes is worth more than its current valuation.
There is no one-size-fits-all method or metric for determining when a company is a good value. Some metrics, such as Price-to-Book Ratio or Price-to-Earnings Ratio, are a good starting point for further analysis.
Often companies become a value when they have fallen out of favor or are no longer the sexy investment choice. Usually, this comes in the form of a mature company whose stock price likely won’t meaningfully go up or down very much. Why invest in these types of companies then? Well, for two reasons: (1) If you’re buying a company for a fair value, there is a better chance you aren’t putting as much negative risk on the table as, say, a growth stock; and (2) value companies typically pay their owners a portion of company profits in the form of a dividend. In other words, you as the investor get paid just to own the company. Pretty cool.
Dividend investing is often tied to value investing, but they are not the same. The objective of dividend investing, also known as income investing or yield investing, is to generate a stream of income. Stocks with high dividend yields are usually very profitable but have relatively low growth rates. As a dividend investor, your job is to find companies with good yield that will be able to continue paying dividends.
Dividend investment strategies are not just about generating money that the investor spends. If dividends are reinvested, a yield portfolio can experience substantial growth too. Companies that pay dividends are typically quite profitable and therefore also defensive during recessions.
Passive investing, or indexing, is a variation of buy and hold investing. However, investments are made in broad indices rather than individual stocks. A major advantage of this strategy is an elimination of the need to select stocks; instead, this strategy ensures you will hold all the significant stocks in the category. Another advantage, if you index in the form of mutual funds, is that you can set it and forget it; the investor can set up automatic purchases of the mutual fund at set intervals. While extraordinarily passive, this is typically an effective strategy in the long term.
Stocks typically generate the highest returns over the long term. However, they are also the most volatile asset class. The more asset classes there are in an investment portfolio, the lower the volatility and portfolio risk will be. A very diversified portfolio may include stocks, bonds, cash, real estate, and other categories.
There are several things to consider when choosing the best investment strategy for you. For starters, the approach should interest you. You will be more likely to learn and do the required research if you find an approach interesting.
Second, your own skills and experience could give you a head start in some areas. For example, value investors need to understand financial statements. If you have knowledge of certain industries, this can also be an advantage.
Another important factor to consider is the time you have to devote to investing. Value, growth, and small cap investing requires a lot of time to do the necessary research. On the other hand, passive investing requires very little time.
Finally, your risk tolerance needs to be considered. Risk tolerance concerns both your financial situation and your temperament. If a volatile investment is going to keep you awake at night, passive investing or a portfolio with broad asset allocation will be more appropriate.
Davis Wealth Management LLC d/b/a Davis Wealth Management. James Davis offers Securities through Concourse Financial Group Securities, Inc. (CFGS), Member FINRA/SIPC. Advisory services offered through Concourse Financial Group Advisors, a DBA for CFGS, a Registered Investment Advisor. Davis Wealth Management is independent from CFGS. Please be advised that presently James Davis holds Series 7 and 66 licenses in NC and SC. For residents of other states in which registration is not held, proper licenses and registrations must be obtained by representatives before proceeding further. No part of this communication should be construed as an offer to sell any security or provide investment advice or recommendation. Securities offered through CFGS will fluctuate in value and are subject to investment risks including possible loss of principal.
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