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by Douglas Gerlach
Millions of Americans are investing their hard-earned dollars in the stock market with the objective of meeting their future financial needs. There are many different approaches to investing in stocks, each of them designed to reduce some of the risk of investing while increasing returns. Below, we outline a few of these strategies. Each comes with advantages and disadvantages, so you should try to find the approach best suited to your own financial situation and goals.
Investing Strategies and Styles
Investing strategies can be broken down into two broad categories: technical analysis and fundamental analysis. They are as different as night and day, but each camp has its followers and its critics.
Technical analysis is an attempt to use price charts and other mathematical indicators to predict future price movements of a stock. The method doesn't look at any outside factors, such as the company's financial statements or the overall economic outlook. It's strictly by the charts. Market technicians believe that the market price of a security reflects all known information about that security.
The downside of technical analysis is that it's very, well, technical. Although there are some excellent software programs specifically for technical analysis, the learning curve to just get started using these techniques can be formidable. Another disadvantage of technical analysis is that it requires you to actively follow current and potential holdings, reviewing charts and indicators each day or week. This means being glued to your computer screen for hours at a session, and can require ample number-crunching skills. Finally, technical analysis is often a short-term strategy, requiring you to make frequent trades and to pay the commissions and short-term capital gains taxes that result (that is, if you have any gains!).
Opponents of technical analysis believe there is no direct cause-and-effect relationship between a stock's past price performance and its future performance, and that relying on chart patterns is a bit like expecting it to rain on June 21st if June 10th is sunny, just because that's what happened last year.
Market timers use technical analysis to try to determine when to buy or sell a particular security, or to get in or out of the market in general. Market-timing systems usually examine reams of data and try to find the best signals indicating when to buy and when to sell. Unfortunately, short of gazing into a crystal ball, there is no reliable way of knowing when the market will turn in any direction, at least in the short term. In the market correction of 1987, only a handful of the experts on Wall Street were able to predict the impending downturn.
On the opposite side of the coin from technical analysis is fundamental analysis. Fundamental analysis can be described as the study and purchase of companies, rather than stocks. Factors such as a company's growth rates, balance sheet, and quality of management are analyzed to determine the true value of a security. Fundamentalists aren't concerned with price patterns on a chart, but with indicators of a company's underlying financial strength.
When you go shopping for a new car, you probably try to buy the best car you can for the best price. You want a vehicle that will run for a long time without breaking down, at least as long as you need. You don't want to have to think about whether or not you'll make it work each morning, you just want your car to get you there. You want a car that will require as little maintenance as possible, not one that needs a tune-up every few thousand miles. And you want to get it for a good price. If you can get a well-made car that fits all your needs, at an affordable cost, you'll be one happy car-owner.
Investing in common stocks isn't much different. You can buy the stock of a high-quality company at a good price, put it away in your portfolio, and not worry about it except during your occasional portfolio checkup. Over the long term, that company can grow and may see its stock price appreciate as a result, and your portfolio will become all the richer. Since you're not trading frequently, you won't have to worry as much about taxes eroding your capital, or paying a lot in commissions.
Just like shopping for a car, however, you need to do your homework first in order to make sure you're getting a good deal on a good company. By investing in quality companies at reasonable prices, you can minimize your risks and increase your returns.
Sounds like a reasonable approach to investing in the stock market, right? You wouldn't buy a car based on a chart of all the car prices at all the dealers in town without any identification of what make or model each was, so why buy stocks for your portfolio that way?
There are many related strategies investors use to select stocks within the spectrum of fundamental analysis.
Value investors look at how much a company is worth based on the worth of all its assets, and at how well the company uses its assets to grow its business. If the company's stock price doesn't reflect the full value of its assets, the stock is considered undervalued. If the stock price increases to reflect the company's underlying worth, perhaps over a period of years, the shareholder is rewarded. Warren Buffet is a well-known value investor, and his company, Berkshire Hathaway (Brk.b), has grown as a result of its investments in companies like American Express Company (AXP), Coca-Cola (KO), and The Washington Post (WPO).
Growth investors look at how quickly companies have been able to grow their sales and earnings in the past, and how that growth is likely to continue in the future. Then they look at the current price and determine if it reflects the potential future growth of the company's businesses. By buying companies that are growing faster than other similar companies, these investors hope to see their investment grow over the years. Peter Lynch primarily used a growth investing strategy while he managed the Fidelity Magellan fund, turning in the all-time best historical performance of any fund.
Many long-term investors combine aspects of growth and value investing in their personal strategy, looking to identify undervalued stocks that have the potential to grow in the years ahead. By using techniques of fundamental analysis, you can build a portfolio of stocks to hold for the long-term, allowing the stocks to grow over the years. In addition, you can use dollar-cost averaging to add more shares to your portfolio on a regular basis.
Finding the Right Approach for You
No investing strategy is right for everyone - but you can determine if a long-term, buy-and-hold stock investing strategy will work for you. Here are some of the questions you should consider:
How much time do you have to invest in your investments? Your time itself is an investment, since it can pay off later when your portfolio begins to bloom as a result of your efforts. If you're just getting started in stocks, you can expect to spend some extra time up front on your investment education, as well as analyzing possible candidates for your portfolio. But once you get the hang of it, you won't need to make an enormous time commitment. You typically need only a few hours each month to study and manage your portfolio.
How much money do you have to start building a portfolio? The good thing about being a long-term stock investor is that you can start small, and build a portfolio of quality stocks over time. Plus, you can add small amounts each month and buy additional shares of stock, helping your portfolio to grow.
Can you identify quality growth companies for your portfolio? In our next lesson, we'll show you some of the criteria you should consider before buying stocks you can hold for the long-term. You can probably identify many of America's prominent companies by name: PepsiCo, Colgate-Palmolive, Coca-Cola, Microsoft, and Starbucks. It shouldn't be surprising that over the years these companies have generally done well for many shareholders. You can reduce your risk by buying quality growth companies at good prices.
The majority of investors find that a growth and value strategy works well for them. By using dollar-based investing to purchase and hold stocks for the long-term, your portfolio can grow through the years.
Become a Disciplined Investor
Once you find your investing style, stick with it. Over time, you'll develop your own set of criteria to pick stocks. If you try mixing approaches, you'll just wind up diluting the effectiveness of your chosen strategy and probably diminishing your returns.
Sometimes this means ignoring the talking heads on television, with their advice to "buy, sell, or hold" a particular stock. Just remember that these analysts aren't managing your portfolio. They may have a very different outlook and time frame than you do, and their advice may not be suitable for your circumstances. You'll have to learn to avoid the hype, as this article explains: "How to evaluate an investment Part 1: Headlines, hype, and your financial horizon."
Sometimes this means remembering that you shouldn't buy a stock just because you have a "good feeling" about the stock's chances. You shouldn't be an emotional investor, buying or selling on a whim or because of "gut instinct." The most successful investors are usually those who have a system that works - and stick to it.
Tomorrow:
Picking Stocks for the Long Haul
Learn how to pick the right stocks for the long run
Further reading:
Evaluating Investments: Part 2
Tracking Investment Performance
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Topics This Issue
Investing Strategies
The Right Approach for You
The Disciplined Investor
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Key Points
Technical analysis considers the past price movement of a stock, usually by studying price charts, in order to predict future changes in price.
Market timing is the attempt to anticipate big swings in the market, and move your money in and out of stocks in advance of those changes. It's often an exercise in futility.
Fundamental analysis is the attempt to invest in good, strong companies that have potential for success.
Value investors often look for companies that have been beaten down in price, and whose intrinsic value is higher than their current share prices.
Growth investors look for companies that are growing solidly over time.
Mark Twain once said, "There are two times in a man's life when he should not speculate: when he can't afford it and when he can." A sound investing strategy is the antidote to speculation -- don't gamble with your investments, but use common sense and patience to build your portfolio over time.
There's an old Wall Street saying that says "Discipline is more important than conviction." When you stray from your investing discipline, you put your portfolio at risk, since it's easy to be fooled when you're excited about a new investing opportunity
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