How To Choose Your Investment Style
After you’ve decided on your investment objectives, it’s time to pick the right investment style to suit your needs.
By investing in single stocks? Or would you prefer instant access to more diverse investments through a fund? Will you update your investments frequently? Put them in the hands of an expert? Or take the ‘do nothing’ approach? There are several possibilities and there’s only one person to decide which one is best for you. In this chapter, we show you the upsides and downsides for each of them to help you decide.
6.1 A Passive Investment Style
Passive investing is based around doing nothing. This simple, step-by-step process illustrates how passive investing works:
1. Invest your money.
2. Sit back and forget about it. Take a nap.
3. Wake up a few years later. Take a satisfying look at how your investment has grown.
4. Buy that Porsche.
What happens while you’re sleeping? There is very little buying or selling. In fact, the concept behind passive investing is that you keep buying and selling to a minimum.
No fees please
This deserves some explanation. First of all, buying and selling attracts fees. The more you buy or sell, the more fees you pay. It might not seem like much. But there are day traders who buy and sell as much as ten times a month, and in some cases, ten times a day.
And if they’re doing this with your capital for thirty or forty years? The fees add up to a lot of money. How much? You could end up waving goodbye to your Porsche. But passive investing means you don’t trade as frequently, so you don’t pay buying and selling fees and as such, you don’t lose that money.
The reason you would usually buy and sell stock on a more frequent basis is to try to beat the market. This means you invest in particular stock when you expect the value to rise. When you think it’s stopped rising or might start falling in value? Then you put your capital in a stock option that looks like it’s ready to rise. And of course, you pay all the related fees. What fun!
Passive investing doesn’t try to beat the market. All you want to do is grow with the market. Nothing more, nothing less.
This raises the question of how you could possibly measure the performance of a market. You might remember looking at indexes back in Chapter 3 about the different types of investements. We established that a market can be anything, from a country, to a specific industry or a certain group of commodities.
Let’s say you are interested in investing in the United States, or more accurately, the huge range of companies and industries that are based there. And why not? They’re what make the US such an economic powerhouse!
There are different indexes that measure the performance of what you could consider to be the US market. The most famous of these is the S&P500 index. S&P simply refers to Standards & Poor’s, the company that crunches the numbers in the index. The 500 relates to the number of companies it indexes. This means the index measures the stock price performance of the 500 largest companies in the US.
This means the S&P500 index doesn’t actually measure the performance of every company in the US market. It uses a sample of 500 to give an approximation of the way the market is performing.
More accuracy with your index
Would you like more accuracy? Because it’s available. The Wilshire 5000 index measures the stock price performance of almost every US company that is publicly traded in the US. There were originally 5,000 companies indexed, but that number has since grown. This may be why the Wilshire 5000 is also known as the ‘total stock market index’.
It’s important to understand how an index is calculated. The S&P500 doesn’t simply take the performance of the different companies, add the figures and then divide the total by 500 to receive an average performance.
The companies are weighted within the index. This weighting usually relates to the market capitalisation of a company. In short, the bigger the company, the more it counts in an index. In case of the above indexes, the performance of Apple impacts the index the most, as this is the biggest company in the US. And the entire world.
Now, betting on a market instead of single companies might not make you rich overnight, but it will reduce your risk and you will still profit from decent returns in the long term. For example, the S&P500 has grown an average of 10% every year since its inception in 1928.
If you compare this kind of market performance with the performance of an actively managed mutual fund, you’ll quickly remember that most funds do not actually perform as well as the index they’re trying to beat. This is the most popular reason why people feel inclined to follow passive investments. Why pay someone high fees to hunt for investment opportunities, if these opportunities aren’t as good as the overall market performance?
One reason is that an index is an index and not an investment. It’s a computation that measures the performance of a specific market. Which means you need to know how to invest in the market.
Index funds, trackers and ETFs
You’ve decided which market you want to invest in. You may even have identified a particular index for that market. Great! The next step? Finding a fund that invests in your market by replicating the index.
This doesn’t mean looking for an Asset Manager. Because an Asset Manager is going to try to beat the index. And probably fail. Instead, you’re probably going to be looking for dull, super-nerdy investors with incredible number-crunching skills. This is because they are the ones who use computer algorithms to create funds that invest in exactly the same companies, commodities or other assets that are being tracked by the index you want to replicate.
This kind of fund is often called an ‘Index Fund’ or a ‘Tracker’. These may not seem like imaginative names, but they’re being created by dull investors with accounting skills instead of imagination. And you’ll be happy to know that instead of thinking of cool names, many of the investors spent their time putting their funds on the stock exchange. These funds are then called ‘Exchange Traded Funds’ or ‘ETFs’.
Do you remember looking at these types of investments, way back in Chapter 3>? What you need to remember is that not every ETF tracks an index. Most of them do.
Replicating an index
Replicating an index is much less work than chasing dreams of investment returns. In fact, the index is often replicated automatically. This is done with clever computer algorithms that save you plenty of time, energy and costs: ETFs cost just a fraction of the cost of an actively managed fund.
The cheapest trackers charge as little as 0.10% on your investments, compared to an actively managed fund that averages around 1.5%. This basically means that the active Asset Manager needs to out-perform the ETF by at least by 1.4% just to equal the performance.
But do be careful. Read the small print. There are niche index funds that charge almost as much as active funds.
Although index funds replicate markets, they don’t necessarily invest in companies alone. They may also invest in bonds or commodities. This means you can use index funds to invest in US government bonds, European corporate bonds or even oil. The opportunities are endless. Why follow an index that invests in bonds instead of companies trading on the stock exchange? It reduces risk.
Would you like to look more closely at the different tools for searching the ETF world? Start with these:
There’s always risk when you invest.
And this is especially the case with passive investing. You don’t even try to avoid the downturns on the market! Let’s say you invest in an ETF following the US market. And then the US economy takes a serious hit. Your investments will too.
However, when you make passive investments, you’re usually investing for the long term. Remember, you basically sit back and wait a few decades until the alarm clock sounds to tell you to divest. In this time, you’ll be exposed to ups, downs, financial crises and all sorts of short-term corrections. Make sure that you’re willing to accept this risk!
It’s only responsible to find out something about the liquidity of an ETF. After all, although you have your rainy-day fund, you might find you need extra cash. ETFs are traded on the stock exchange which means investors are happy to buy and sell ‘shares’ of the ETF. All good. As long as the companies that make up the market are performing well, the share price will remain strong.
The pros of passive investing
One of the biggest benefits is obviously the time you save. You simply invest and then your time is your own. There’s no real homework. There are no especially great demands being placed on you.
Next up? The fees you save on buying and selling. And the actual costs involved? Depending on where you invest, the costs could even fall under 0.10% annually. At the other end of the spectrum? The highest rates are about 0.5% annually. This is still well below the rates demanded by most active investment schemes.
There’s another big benefit that people often fail to realise. When you decide to invest passively, your decision isn’t set in stone. There’s no reason why you need to make a decision today that will stay in effect for the next forty years. You might choose to review your investment strategy in five years. Or to reassess every ten years. Perhaps you choose to invest in high-risk options for ten years, followed by a different mix for twenty years, then a low-risk portfolio for the ten years after that.
If this looks most appealing, make sure your investments allow you the option of changing without enormous penalties. We look at these strategies in Chapter 7 about building your investment portfolio and in Chapter 8 about investment management.
And the cons of passive investing
The biggest downside to passive investing? Doing nothing isn’t easy. When they see their stocks are doing poorly, many investors have an incredible urge to sell their interests immediately. The reality is that setbacks are expected and a normal part of passive investing. There’s no need to worry too much about them. Everything should even out in the long term. But you’ll probably still stress out.
If you’re involved in index investing, another downside is the way in which indexes are composed. It doesn’t matter whether a company does well or not, it could still be included in an index. This means there might be some complete duds. And like it or not, you’ll still be investing in them. Of course, if your investment is doing well overall, it shouldn’t matter.
6.2 Active Investment Style
The aim of active investing is to beat the market. It requires input, continual buying and selling, constant monitoring of investments and a keen understanding of any conditions or circumstances that could raise or lower the value of a particular stock or security. As an active investor, you’ll regularly buy shares in options that have a low price and sell them when the price has increased. You buy and sell shares to realise a return that is better than what the market is offering. You sell shares in interests that are not performing particularly well and invest the capital in interests you suspect will do well in the near future.
The idea is that by eliminating the losses, or slow appreciation, you optimise your capital and receive the best returns possible, better than what the market is offering. You might think this sounds pretty demanding. That’s why most active investors hire someone else to do it all for them. All for a certain price.
Fees, costs and the bad news
It’s definitely possible to do better than the market. But as we have already discussed, you have to do a lot better. Because it’s not just the return rates you’ll have to consider. It’s also the fees you pay every time you buy or sell stock. Trading fees will vary depending on the market. But they add up.
There are also the fees you pay your fund manager. They probably don’t look too bad. The average usually hovers around 1.5%. But when you think of what this 1.5% amounts to over a period of thirty years … It adds up. And remember, 1.5% is the average rate. You might end up paying even more. Also keep an eye on nasty entry and exit fees. These can come with a very high price tag.
These are obviously some of the biggest disadvantages. But there’s one more you’ll really have to take into consideration. Despite paying all these fees and costs, there’s no guarantee that you’ll actually out-perform the market. In fact, 70-80% of active investment funds don’t beat the market. And when you take into account the different fees and costs involved in active investments, there’s a real risk that you’ll come out behind. You could lose money.
Advantages of active investing
It’s time for the good news! This extends beyond acknowledging the very real possibility that your investment will beat the market. Because there are other benefits you’ll enjoy with active investing:
- Flexibility. You don’t need to hold onto a stock or bond that’s performing poorly. Don’t like it? Ditch it!
- Hedging. This is where you use short sales, set options or strategies to ensure you won’t suffer a loss.
- Risk management. Let’s say you’ve invested in a market in which the level of risk suddenly rises. Let’s say it’s the wheat market. The weather conditions have been poor for growing wheat, there’s an unusually high population of hungry locusts and, just to really cause trouble, gluten is scientifically proven to be bad for all humans. You won’t have a problem jettisoning that investment.
- Tax management. This will depend on the relevant tax laws, but in some places, you’ll be able to sell investments that lose money to offset the taxes you pay on the investments that bring the cash in.
Last of all, there are certain niches, such as small companies and emerging markets that active investors will know about, but which you as an individual investor are unlikely to know much about or have time to research. The 1.5% you pay every year could pay off in such an instance. There’s always another Google or Microsoft out there waiting for someone to invest in them.
6.3 Single Stocks
There are different approaches to investing on the stock market. It’s possible to invest in specific single companies. Alternatively, there are also funds that group interests in numerous stocks from a single industry. Many of these are funds. There are ups and downs to both these options.
Single stock investments
You might decide that a particular industry is of no interest to you. Except for a single company. You add stock in this company to your portfolio. How much stock you buy is entirely up to you. As is the percentage of your portfolio that the stock represents. It might be the only company in your portfolio—which is incredibly risky. Or, it could be one of many investments. That’s also risky, but definitely not as dangerous as if you only had one company in your portfolio.
The other investments might be single stock investments as well. They could also be funds, bonds or anything else.
When you invest in single stocks, it’s typically because you’ve done your research, know the company and have a pretty good idea of what’s on the horizon. You have complete control over where you invest and when you make the investment. But there are other benefits beyond this.
First up, there are lower fees when you buy single stocks. You don’t need to pay fund managers or the annual management fees often associated with funds. But be careful. If you buy and sell shares with low investment amounts too often the transaction fees will take a big bite out of your returns. Paying fewer fees is always good news. As are simpler taxes. Tax does differ from country to country and region to region, but typically, buying and selling single stocks simplifies the ordeal.
The downsides mostly relate to risk. The fewer companies you have your capital invested in, the higher the chance of your investment failing. You’ll probably be quite upset if even one of these companies performs poorly. And even more upset if one goes bankrupt. But suppose you have your capital spread across several companies in the same industry? You’ll have to hope the industry performs!
Individual stocks take more time to monitor. Are any of the companies you’ve invested in facing business problems? Are there any external threats you’ll have to look out for? Make sure you don’t miss anything important!
As the manager of your own portfolio, you do have control over what you purchase. You’ll also need control over your emotions. Because you’ll hear plenty of great tips about incredible opportunities that you won’t want to miss! As well as horrible news about companies that you’ve already invested in.
Tips will encourage you to buy and sell at a moment’s notice. It might work out to your advantage. It might not. But what if you do your homework and really understand the future of the company you’re investing in? You could be too late to take advantage of a particular opportunity, but at least you’ll understand exactly what the opportunity was, learn something and otherwise benefit from the experience.
How to pick stock
Most investors pick stock based on extensive analyses that help them decide whether a particular stock will make a good investment or not. This is called forecasting. The information could be based on any number of factors. In fact, there are so many different factors involved, it’s difficult to take them all into account.
Especially since they have different levels of influence. And because not all of these factors can be accurately measured. Profits? Easy to measure. But reputation, staff performance and competitive advantages? Far more difficult to tally. And this is why forecasting is not an exact science. There is no secret, magical formula that shows how a specific company or market will act in the future. Sorry.
There are other factors that come into play here too. One of these is emotion. Because emotions influence the choices you make. Perhaps you want to see a specific product succeed. Maybe you like a product, but don’t realise it doesn’t really appeal to a wider market.
Of course, the opposite could also be true. The wider market may see the benefit of a product while you’re left scratching your head. There are also fads that come and go.
Bob felt very comfortable investing in Gin Co. And it was a huge success. Bob is very happy with the way his stock has performed over the past two chapters.
In fact, Bob and Mrs. Bob have gone out to celebrate. At the bar, Bob notices there are now seventeen different types of gin on the menu. Many of them have names like ‘Ginko’ and ‘The Original Gin Co.’, but Gin Co. itself is still listed. There are several people around Bob drinking a variety of different brands of gin. The people who aren’t drinking any gin are the uber-cool, ultra-fashionable, influential, trend-setting people. Bob decides to sell his interest in Gin Co.
There are other potential traps. What if someone you respect keeps talking about the brilliance of a product. Would Nespresso be as successful if George Clooney wasn’t selling it? Some commercials have a huge influence on certain consumers, whereas you might be more effectively swayed by a different approach.
Your investment advisor might try to push a certain investment opportunity. Why? It’s often because it truly is a great investment opportunity. But there are an increasingly large number of situations in which advisors have more underhanded reasons. Put simply, your investment advisor works for a specific company and this company will often stand to benefit from investments in the proposed stock. This makes it difficult to know who to trust.
Choice, freedom and ethical investing in stock picking
The difficulty involved in picking successful stocks is definitely a downside. You also need to ask yourself whether the uncertainty and doubt are going to keep you awake at night.
But there are also very clear positives to stock picking. Think about the ethical investments we covered earlier in Chapter 4. When you pick your own stock, it’s easy to stick to your ethical values. But remember, although you might not see a problem in a certain company, other consumers could. Of course, your ethical predilections might ward off a potential money maker, but this definitely shouldn’t make you backtrack on your decision.
Stock picking also gives you a lot more freedom over what you include in your portfolio. Remember we discussed how indexed investing may result in a fund putting capital in a company that wasn’t really performing well? Picking your own stock, you’ll have the option of deciding whether to include it in your portfolio. And if there are stocks that are performing particularly well? You have the choice of increasing your investment in them. Which is an interesting power to have. Especially since there’s always a possibility you’ll invest in a stock option that performs exceedingly well.
At the end of the day, you’ll have to remember there is no one else to blame if things go wrong. And there will be no one else taking home the profits if everything goes well.
6.4 Additional Reading
This guide is for educational purposes only, and should not be seen as financial advice.
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