+ Learn the difference between active and passive investment strategies.
+ Distinguish between fundamental analysis and technical analysis
+ What is Value, Growth and Income investing?
+ Why buy and hold?
Lecture: Investment Strategies
The Efficient Market Hypothesis (EMH) proposes that no investor can systematically outperform the market. Once all relevant information is incorporated into asset prices, price variations are random, and therefore unpredictable. Yet stories of individuals or funds consistently doing better than the market are legend, and the “market” for strategies is alive and well. What are these strategies, and is there substance to claims that investors can make above normal returns if only they follow simple rules?
Part I – Passive or Active investing?
If an investor believes in the EMH, then passive investing is not only the choice, but the only choice, to make. No point in paying managers to beat the market, and no point in wasting time and energy attempting it yourself, as it’s a fool’s errand. Investing in ETF funds, or ETFs directly is the embodiment of passive investing these days.
Aside: On beating the market.
The EMH says you can’t beat the market. If all investors actually believed that, there would be no fund managers, only index funds, and the billion dollar investing industry would disappear as we know it. There are enough celebrity investors, and enough advertizer supported get rich quick websites, to convince some investors they can beat the market. Below is a screenshot from the MarketWatch website showing the performance of eight managed portfolios in September 2016. Each portfolio return over selected periods from one to ten years is compared to that of the S&P500 Index. Notice how the Index (a good reflection of the market) outperforms all eight portfolios over ever period!
Active management (picture investment analysts reading the newspapers, following company announcements, working with computer software–not the people depicted in Wolf of Wall Street) doesn’t have a great track record, but it is the only way to outperform the market. (By definition, an index fund’s performance matches the index, or market!) And herein lies the dilemma of investing–active management is the only way to beat the market, but active management has a poor record of beating the market. Active management is the world of investment strategies (even though passive investing is still a strategy, it’s not a very exciting one.)
Part II – Growth, Value or Income Investing?
Investing strategies are often grouped into three types or labels: Growth, Value or Income. Although the distinctions are sometimes not so clear, there are some basic qualities to each generic strategy.
Value investors are looking for solid companies with good products or services that produce profits over long periods of time. In particular they are looking for companies that are under-valued by the market. If the current market price is below the inherent value of the company’s stock, the stock is a buy recommendation. Calculating the true value of the company requires fundamental analysis and considerable judgement. Warren Buffett is perhaps the most famous value investor, but he claims to have been heavily influenced by Benjamin Graham, the so-called father of Value Investing. Value investing is often associated with the “buy and hold” long term investment strategy.
Growth investors are also looking for companies with good profits or profit prospects, but they have a shorter time horizon than value investors. They are concerned more with (positive) change in value rather than the absolute level of prices, or the difference between inherent value and current price. Growth investors don’t like sitting through the times that a good company is not growing strongly, whereas value investors are more likely to accept the ups and downs of a basically good (growth) company.
Income investors are interested in a portfolio that produces a regular stream of income, which usually means bonds, dividend-paying stocks, and perhaps REITs. Like value investors, income investors are looking for companies with strong fundamentals that are likely to produce a steady flow of income to investors or creditors each and every year.
Although it is tempting to classify investment strategies using these three general classes, in reality investors use strategies–either explicitly or implicitly–that combine elements of all three types.
Part III – Technical analysis
Technical analysis is a general term covering analysis and strategies based on identifying trends and divergence from trend, or identifying patterns in asset prices and volumes. In its most extreme form, technical analysis is data mining and number crunching with little or no regard to the company name, its business, its industry or any other fundamental quality of the company. In the extreme, a technical analyst, or “quant” couldn’t tell you what business the company she was analyzing was in…
Technical analysis has become easier thanks to advances in computing, especially personal computing. Analysts have enough computing power on their desks to crunch millions of numbers almost instantly. This makes it easier to perform technical analysis, but what numbers to crunch, and what to do with them requires skill and experience.
The basis for technical analysis comes from economic theory: the market price is a function of the interaction of supply and demand, which themselves reflect everything buyers and sellers know, or feel, about the product, or company in the case of shares. In economic theory terms, the supply and demand functions are structural equations, whereas the price and quantity functions are reduced forms. What this means is that all the factors that influence demand, or supply are present and reflected in the price and quantity functions. It’s difficult to pull these factors apart but quants don’t bother with that–all they need to know about “why” is contained in the prices and volumes they observe, and analyze.
Although technical analysis is conducted using high powered computers, programs and fancy algorithms, there is a lot of psychology behind technical analysis. For example, the notions of support and resistance stem from an observation that asset prices tend to stay within “bounds” – an upper limit and a lower limit. Support is the price below which the stock price, for example, rarely falls. If it does, this may trigger a buy order. Resistance is the price above which the stock price rarely rises. If it does this may trigger a sell order. Technical analysis can also be used to confirm ideas about “threshold” prices. Once a stock price goes above $100, for example, the stock may be considered in a different league than before, with different expectations from investors.
Check out this quote from investor Benjamin Graham:
“The one principal that applies to nearly all these so-called “technical approaches” is that one should buy because a stock or the market has gone up and one should sell because it has declined. This is the exact opposite of sound business sense everywhere else, and it is most unlikely that it can lead to lasting success in Wall Street. In our own stock-market experience and observation, extending over 50 years, we have not known a single person who has consistently or lastingly made money by thus “following the market.” We do not hesitate to declare that this approach is as fallacious as it is popular.”
Aside: Buy and Hold
A stalwart strategy is the buy and hold strategy, which does well for those with longer time horizons and those looking for retirement investments. As mentioned above, Value Investing is often associated with buy and hold, because investment terms are longer and companies with long term value are being sought. Buy low, wait and hold, sell high–sounds simple and it is.
Aside: Day Trading
Day trading sounds like a whole lot of fun. Wake up in the morning with a coffee, stay in your jammies, and maybe your bed, and buy and sell stocks until 4pm when the market closes… Unfortunately the truth is not so romantic. Day trading is hard work, and the rewards are directly proportional to the effort exerted. It can be profitable, but it’s generally believed that only 5% of day traders make a living from the venture. Those aren’t good odds… There are many articles on the internet about day trading, and here’s an overview from Investopedia.
Aside: Psychology of Investing and Common Biases
When deciding on an investment strategy it is important to recognize the role emotions and general human behavior plays when making decisions. Psychologists and economists have identified a number of common behaviors or biases in investors. I won’t list them all here (this article describes most of the common ones,) but just note that most of them seem pretty obvious when called out. For example, the disposition effect describes the common observation that investors tend to wait a little too long to sell losing stocks, and sell winning stocks a little too quickly. People don’t want to admit they made a bad decision, and so worsen a losing position by staying in it longer than necessary. The opposite is true for a gaining position – the longer it lasts the more likely people think it will end, so they abandon the position prematurely.
Whatever strategies are chosen, and they can change with circumstances, and over a lifetime, they should match the investment goals. A great short term strategy is no good if your goal is long term. Buy and hold can be terrible if the investment term is short and the market moves against you.
The Quiz is available on the Learn website.
1. Investopedia’s brief introduction to 7 investing strategies:
2. Vanguard research paper comparing active and passive mutual funds:
3. An interesting reflection on buy and hold from Yahoo Finance:
4. Two articles from The Economist. The first comparing hedge fund and ETF fund performance, the second arguing why hedge funds might not offer the best strategies for the people they are marketed to:
No homework for this topic
Discuss the following question:
1. What is your preferred strategy for long term investment goals like retirement and why?