Investment Strategy

What is an Investment Strategy?

An investor’s fundamental approach to trading can be referred to as an investment strategy.  An investment strategy will provide a set of rules that the trader can follow; such as, time frame, technique, and investment type.  In this article, we will cover various items that you should consider when you are creating your investing strategy.

Active or Passive Trading?

To define your investment strategy, you must first understand your psychological makeup.  Do you like taking a more active or passive role in your trading?  More active investors gravitate towards day trading or swing trading stocks while passive investors will feel more comfortable picking stocks for the longer term and create an investing strategy with an intermediate to long term (buy and hold) time frame.

Asset Class Diversification

The next area that we will talk about is very important because most people don’t get this one right.  Which asset classes will you invest in?  Think about this, most investors who use financial planners are given investment strategies which diversify their assets into small cap, mid cap, large cap, and a portion into bonds or fixed income.  The financial planner will adjust the percentages as your risk parameters change with age.  Some investing strategies will also have sector specific exposure in areas such as foreign markets, biotech, technology, or banking stocks.  At the end of the day, stocks are stocks and the majority of them will move together.  The point I am trying to make is that diversification within the same asset class is no diversification at all.  Secondly, diversifying your portfolio into different asset classes for the sake of diversifying is also a bad investment strategy for long term gains. 

Investing is not easy and there is no such thing as a single best investment strategy.  However, the cookie cutter investing strategies should be a thing of the past.  Investors need to focus on creating an investing strategy which is a bit more granular.  It is important to expand your horizons and involve many of the different asset classes available for investment; such as, stocks, bonds, commodities, currencies, and international markets to name a few.  Even more important is to have a solid fundamental and technical opinion on these areas so that you can maximize your investment mix with securities which present the best risk/reward setup.  What I am NOT suggesting is that you day trade your retirement assets; however, what I am suggesting is that you take a more active approach to investing into areas which present great opportunity rather than sticking with ones that do not.  For example, look at the great bull market in oil & oil stocks during the 2003 to 2008 time frame, the great fall in the US dollar over the past few years, and the rise in gold & platinum from 2002.  Did you take part?  I think you get the point, if you have handed your assets over to an investment advisor, make sure you have selected someone who is capable of creating an investment strategy which accounts for asset diversification; rather than the traditional model.

Investing Approach

A sound investing strategy will include both fundamental and technical analysis.  Understanding a company’s business model and being able to dissect their financial reports is a great skill to have but it won’t necessarily correlate to the price of a stock. 

While most do not like to believe in a “conspiracy theory”, the truth is that the market shows signs of bottoming or topping well before the fundamentals do.  Large institutions & money managers need a bullish environment to distribute their shares at higher prices and will support such an environment until they are able dump all of their shares.  Conversely, the best time to move a large amount of money into the market is when there is excessive pessimism and fear.  This is what technical analysis will help you uncover.  The theory behind technical analysis is that patterns will repeat themselves over and over again in the market because human psychology will never change.  The saying “put your money where your mouth is” fits very well here.  There is no better indicator to stock prices than the direction in which the money is flowing.

Fundamental analysis can definitely assist in helping you select the best companies but will fall short in actually helping you buy at the most opportune time.  This is why technical analysis should be included in anyone’s investment strategy.

Popular Investment Strategies

Automated Trading Systems


Many traders, and even institutions, will create an investment strategy using back-tested data to predict future price movement.  Many times, these systems can work quite well for a period of time; however, I would say that the majority of them go bust.  When they start failing, it is very difficult to catch them in time before you lose quite a bit of money.  For this reason, I stay away from automation.  Don’t be sold on a dream.  If it was that good, why would someone make it available to the public?  If you must go with an automated investing strategy, make sure that there is risk management built into the system and also have an exit strategy in the case that it stops working.

Pairs Trading

Another popular investing strategy is known as pairs trading.  While this terminology is primarily used in forex trading, we will talk about it in a different light.  Pairs trading allows you to make a bet on the direction of two different stocks relative to each other, rather than the market.  This investment strategy takes advantage of large discrepancies that arise in the spread between the two securities.  The idea behind pairs trading is to select two highly correlated stocks which exhibit repeatable patterns in terms of the spread between the two.  We want to see the spread become historically extended and then see this spread revert back to the mean; over and over again.  For example, assume that you created an investment strategy which traded the KO(Coke) / PEP(Pepsi) pair.  When this ratio becomes historically extended to the upside, you can short KO and buy PEP in equal amounts.  Once the spread between the two reverts back to the mean, you cover both positions for a profit.

Conclusion

Selecting an investment strategy requires a lot more work than you would think; however, the hard work will pay off at the end of the day when you are looking to retire.  While the discussion around the best investment strategy will continue till the end of time; a good strategy is one that aligns itself to your investment goals and enters into investments which provide the best risk/reward setups.  Whether you manage your money or an investment advisor does, make sure that you are maximizing the potential of your hard earned money in light of your investment needs.
Tim Ord
Ord Oracle

Tim Ord is a technical analyst and expert in the theories of chart analysis using price, volume, and a host of proprietary indicators as a guide...

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