Successful investing requires a commitment to regularly setting aside money and choosing appropriate investment options based on your specific objectives. In making investment decisions, factors that should be considered include investment horizon, portfolio diversification and individual risk tolerance. The pyramid illustrates various investment vehicles, along with their respective levels of risk and return. Risk and return are positively correlated. As such, the higher the return, the higher the risk, and this is usually associated with stocks. This article seeks to address strategies relating to directly investing in stocks.
The buy-and-hold strategy
The buy-and-hold strategy is a conventional approach to investing, in which an investor buys stocks and holds them for a long period of time. It is based on the view that in the long run, equity markets give a good rate of return despite periods of volatility or decline. If your intention is to pick your own stocks, the buy-and-hold strategy had more convincing evidence years ago, but with the advent of lightning-fast information and high-speed trading, it may no longer be a valid argument.
Investors who participated in the lost decade of the United States market (2000-2010) saw long-term gains evaporate with the bursting of two historic bubbles—technology stocks in 2000 and housing in 2008—the last of which brought on the credit crisis. It can even be suggested that the buy-and-hold model became obsolete when the S&P hit 1,527 and the Nasdaq topped at 5,048 in March 2000. Had you put your money to work at this time, you would still be down about ten per cent on the S&P and about 41 per cent on the Nasdaq. This is further exacerbated when inflation is factored in.
Consider the topical example of Research In Motion (RIM), manufacturers of BlackBerry smartphones. These phones became highly popularised around 2005, when PC World called the BlackBerry 850 the 14th greatest gadget of the past 50 years. Say an investor purchased this share in July 2006 at US$20.79; he would have experienced an appreciation of 510 per cent (to US$126.95) in October 2007, just over one year later. This was followed by some instability, but the stock eventually peaked at US$144.56 in June 2008 (an appreciation of 595 per cent from July 2006). Like the market in general, the years that followed were, of course, extremely volatile with an overall downward trend. On July 5, RIM’s share price closed at US$7.69. Needless to say, it never returned to its highest value of US$144.56. Assuming the investor continued to hold the share since July 2006, his overall return would be -63.01 per cent.
An alternative to the buy-and-hold strategy is known as active investing. In pursuing an active investment strategy, investors take their life savings off of autopilot and deal with what is happening in the market on a day-to-day basis. They purchase investments and continuously monitor their activity in order to take profits or limit losses when they have reached pre-determined levels. The objective is to ultimately achieve better-than-average results during favourable, volatile and flat market conditions. Consider the Dow Jones Industrial Average. On January 3, the Dow opened at 12,221 and closed at 12,397 (up 1.44 per cent) the same day. The year started great and peaked at 13,279 (8.66 per cent) on May 1. Investors would have been quite satisfied with their April statements, but just 17 days later, the Dow was back down to12,369, depleting almost all of the gains made for the year.
On the flip side, the Dow opened at 12,101 on June 5, and rose to 12,880 on June 29, (a 6.44 per cent increase). So while it is obvious that markets will rise and fall and that no one can perfectly determine the lowest and highest points for maximum gain, this does not mean that an investor should not realise gains or cut losses on a regular basis.
In a relatively flat market, where opportunities appear limited, an active approach can still be adopted to generate profits. Consider the local market, which has been relatively flat. Year-to-date, as at July 5, the Stock Exchange Composite Index was up by 1.57 per cent, but investors with an active investing strategy, who purchased stocks, such as AMCL, GHL, OCM and WCO at the beginning of the year, would have returns varying between seven per cent to 22 per cent for the same period. By being more active with your portfolio and having a specific rate-of-return goal, you can take advantage of the market’s ups and downs. In the RIM example cited above, had the investor identified a target return of say 300 per cent and committed to selling upon achieving his objective (at US$83.16), he would have earned his desired profit and would have the freedom to move on to subsequent opportunities for short-term gains. All in all, he would be better off than the investor who continued to hold the share to this day. A proper active-investing strategy requires time and energy. This means setting goals for the portfolio, taking gains and cutting losses when appropriate: no more buy-and-hold.
Here are some active investment guidelines:
• Do your research and seek advice from reputable investment experts
• Calculate and monitor key figures and ratios, such as stock value, price-to-earnings ratio, dividend yield, dividend growth, market-to-book value, a strong balance sheet and credit rating.
This will assist in identifying investment opportunities, as well as their buy price, hold price, and sell price
• Monitor technical signals (40-day and 200-day moving averages)
• Stick to companies you understand and are comfortable with
From time to time, financial markets can provide a stable, long-term route to savings, allowing investors the chance to build wealth and thereby protect their savings against inflation. It was often said that the stock market offers the best long-term value. Investors were encouraged to adopt a buy-and-hold strategy. This strategy worked very well during the boom years. Financial markets are now very different. In the last 20 years, financial regulators have sought to control the savings and investment markets, yet they have offered little constraint on the banks through the credit and loan market. The public was encouraged to borrow and discouraged to save. Developed economies such as the United States, Greece and Spain are now heavily in debt. Volatile investment markets have become the norm, which is unlikely to change over the next few years.
Prior to 2008, who would have thought that Bank of America shares would be trading as low as US$8.05? Or that its share price would even hit US$3.14? (Which it did in March 2009.) Furthermore, taking into account that the rate of return on a savings account is around ten basis points (that is, 0.1 per cent), the last five-year returns on equity-based mutual funds are generally either negative or flat and that headline inflation was 12.6 per cent as at May 2012, it is imperative that investors take control and optimise the returns on their investment dollars. This means pursuing an involved, disciplined and active investment strategy. Remember, managing your money is like every other aspect of life, the more time and attention you devote to it, the better your outcome will be.