Now that you have successfully determined how much of a risk-taker you are, it’s time to choose an investing style that best suits your personality, your needs, and your financial standing.
First, you’ll need a basic understanding of the major investment styles available in today’s market. These styles can be broken down into three dimensions: active vs. passive management, growth vs. value investing, and small cap vs. large cap companies. Study each category to determine which style best suits your needs.
Active or Passive Management
When choosing your investment style, your first question is going to be how much trust you’re comfortable placing in financial advisors.
If you’d like to have professional money managers carefully select your holdings, along with a full-time staff of financial researchers and managers constantly seeking to gain larger returns for you, active management is the style for you. Of course, you’ll have to pay for those financial experts to work on your investments, but hopefully, the greater returns you’ll get will make the expense well worth it.
If you don’t think a team of professionals will do enough for your investments to justify the high cost, you might choose to be a passive investor instead. In fact, empirical research supports this style – it shows that many passively-managed funds actually earn better returns over the long run. You’ll need to do more of the legwork yourself this way, but your expenses will also be much, much lower.
Growth or Value Investing
The next question you’ll need to consider is whether you prefer to invest in fast-growing firms or in underpriced industry leaders.
Those using the growth style of investing, will choose firms with high earnings, high return on equity, high profit margins, and low dividend yields. The reasoning behind this choice is that a firm earning in this pattern is likely to be an innovator in its field and will continue earning high profits.
Since it is currently growing at a fast pace, such a firm will reinvest most – or even all – of its earnings for fueling further growth. As an investor, you want a chance to be part of that growth, even if it means paying a higher price-to-earnings ratio.
In contrast, the value style of investing is focused on buying a strong firm at a good price. To be considered a value investment, a firm must have a low price-to-earnings ratio, low price-to-sales ratio, and a higher dividend yield.
Small Cap or Large Cap Companies
The last question you need to ask yourself, is whether you want to invest in small or large companies. In investing lingo, the measurement of a company’s size is referred to as its “market capitalization” or “cap” for short. Market capitalization is the number of shares of stock a company has outstanding, multiplied by the share price.
Some investors prefer small-cap companies because they believe these companies can deliver better returns as they are more flexible, and have more opportunities for growth. As is usually the rule in the market though, the potential for greater returns comes with heightened volatility and greater risk. In comparison to large firms, small firms have fewer resources and a less diversified business line. Share prices of the company can therefore fluctuate dramatically, generating larger gains but also generating larger losses. If you’re comfortable with risk and like the potential for greater growth, this is the style for you.
If the thought of putting your money into a smaller company makes you uneasy, consider investing in a dependable, large-cap company. The names of large caps include some big firms you’ll be familiar with like Microsoft and Exxon Mobil. These companies are well-established and stable; you don’t have to worry that they’ll suddenly go out of business and leave you in the lurch.
On the flipside though, these companies are already so large, that they may have reached their capacity for growth and don’t have much more room for expansion. Investors putting their money into large caps can anticipate lower returns, but also less risk.
Review these three dimensions of investment styles until you can determine which choice from each category suits you best. When you have chosen one from each dimension, you’ll know your investing style. This will enable you to pick the investments that you’ll be comfortable holding onto for a long time.
What kind of investor are you? Share your style with us in the comments!