Investment strategies can be distinguished in various ways, fundamentalists vs technical, passive vs active etc. Investors may fall into multiple categories; these categories are simply descriptions of strategies and act as an introduction to investing.
Passivist investors are considered perhaps the most basic of all strategies, their function to buy and hold a broad range of securities and let them appreciate in value. The rationale of this type of investing is when one company or industry declines, another will benefit or at the very least, not decline as aggressively. This is outlined in greater mathematical detail by Nobel Prize Laureate Harry Markowitz in his PhD dissertation on modern portfolio theory.
“Mutual funds allow an investor to pool money with other investors, thus effectively being able to buy a fraction of a stock. If you and 4 of your friends wanted to give me $5000 each, I could invest that in the DJIA, and you would all own 1/5 of every stock in the DJIA.”
A simple way of implementing the buy and hold strategy is to buy every stock in the Dow Jones Industrial Average (DJIA). The DJIA is an index compiled by Standard & Poor’s LLC, which tracks 30 large capitalization companies - the overall value of the company if an investor multiplied the price per share by how many shares issued. On average, the DJIA returns about 7.75% if an investor is not reinvesting dividends. To buy every stock in the DJIA an investor would need around $25,000.
Fortunately, there are such things as mutual funds. Mutual funds allow an investor to pool money with other investors, thus effectively being able to buy a fraction of a stock. If you and 4 of your friends wanted to give me $5000 each, I could invest that in the DJIA, and you would all own 1/5 of every stock in the DJIA. This investment model has been around for centuries, however the first retail index fund, First Index Investment Trust, was created by the late John Bogle in the 70s. Bogle was perhaps the most prominent mutual fund manager in the world, his firm; Vanguard, is now the second largest money management firm in the world (4.5 Trillion Assets Under Management), only surpassed by BlackRock (6.3 Trillion AUM).
Vanguard’s success can in large part be attributed to its low fee structure. Many of Vanguard’s mutual funds are “No Load” funds. To clarify, when you and your 4 friends gave me $5000, I took 2% out of each and made myself $500, you and your friends only have $4900 invested in the stock market. These are load fees, fees charged for putting money in or taking money out of the fund.
“Templeton continued to hold onto his remaining investment and in 1943, he managed to sell the remaining shares for nearly four times the money he had initially invested.”
To be clear “no load” is not the same thing as “no fee”. Most funds charge fees annually, some funds charge flat rates, while other funds charge based on the total Assets Under Management. The Expense ratio of a mutual fund tells an investor exactly how much they pay in relation to their investment per year e.g. a fund where an investor pays $100 in fees on a $5000 investment has an expense ratio of 2%.
An alternative to mutual funds are Exchange Traded Funds (ETFs). Exchange traded funds are similar to mutual funds in that they allow an investor to pool money with other investors to track an index (or any other underlying asset) but they offer significantly lower upfront cost of investment, coupled with more freedom of when an investor can enter and exit the fund. Typically, mutual funds have a minimum investment of $3000, but it’s possible to enter an ETF for as little as $67. Exchange Traded Funds are traded like stocks on the open market, which means it is possible to enter the fund and withdraw from the fund in the same day. Mutual funds have more structured times of when an investor can subscribe (put money in) and make redemptions (take money out).
Of course, passively investing does not necessarily mean an investor doesn’t have a strategy. An investor could put money into an ETF which tracks an index, or could, as the famous John Templeton did in 1939, purchase $100 worth of every stock which was trading below $1 per share on American stock exchanges. In 1939, that meant Templeton’s initial investment was $10,400. Of the 104 companies he invested in, 34 went bankrupt, a loss of 32.69%. Despite this, Templeton continued to hold onto his remaining investment and in 1943, he managed to sell the remaining shares for nearly four times the money he had initially invested. Research backs up this strategy as small cap index funds such as SCHA (an ETF which tracks small cap stocks) tend to have higher returns than standard large cap index funds.
Other slightly more active strategies include Dollar Cost Averaging (DCA) and Asset Allocation. DCA is where an investor will allocate the same amount of money every month to buy shares in a particular company. In practice, this means when the share price is high, then the investor will buy fewer shares, and when the share price is low the investor will buy more shares. For example, if an investor were to buy $200 worth of shares in company A at $40 a share in January and $200 worth at $50 a share in February, then the investor has bought 9 shares at an average price of $45 a share. Asset Allocation is similar process, where an investor outlines what proportion they want in each asset class, e.g. 25% of their portfolio in common stock and 75% in corporate bonds. If an investor invests $10,000 and bonds go up by 5% ($7875) but stocks increase by 10% ($2750) then the investor must rebalance the portfolio because bonds now make up 74% of the portfolio.
75% of 10,000=7500 which is the value of the investor’s bonds.
7500 ×1.05=7875 the value of the investor’s bonds after the 5% increase.
2500×1.1=2750 the value of the investor’s stock after 10% increase
78752750+7875?74% the proportion of bonds in the investor’s portfolio after growth.
This strategy is used to take emotional choices out of trading.