Investing Strategies

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.

What are Defensive Stocks

Defensive stocks are securities which do not react strongly to movements in the broad market.  These stocks are generally companies which provide services that consumers need on a daily basis and are not generally purchased with disposable income.  Defensive stocks will not provide stellar annual returns because they are not large earnings growth stocks.  However, these stocks will normally have low p/e ratios with high dividend yields. 

Restaurant Stocks

Restaurants are always a solid defensive stock play.  Now this does not mean high-end restaurants with no free refills on drinks, but less expensive establishments like Bob Evan's, T.G.I.F and Red Robin can actually see a pickup in business during a economic recession.  This does not mean these stocks are immuned to a bear market, but they will generally outperform the market.  While families may cut back on $50 dollar dinners, people still have to eat out somewhere.

Amusement Parks

Americans always look forward to their two weeks of vacation where they can take the family down south or out west for some warm weather.  But with the recent pain in the economy, many families are cutting back on the expensive family trips.  Consumers are electing to stay local and take day trips to the local amusement park.  This allows the family to still have fun but without the increased costs of transportation and a weeks worth of lodging.

Household Goods

Household goods are a no brainer.  People still need items like aluminum foil, tape, tupperware, and sponges.  Look to pickup stocks of companies that produce generics of household items.  While consumers may need paper towels, they may go for the store generic brand to save a few bucks.

Defensive Stock Chart Examples

The below charts are of some defensive stocks which outperformed the market during the credit crisis of 2008.

Wal-Mart

The Procter & Gamble Company

Coca-Cola Company

What is Pyramiding?

Pyramiding is an old trading strategy where a speculator adds to their position size by using margin from unrealized gains.  This trading strategy is based solely on the power of using leverage and was made popular by one of the greatest traders of all-time, Jesse Livermore.

Example of  Pyramiding Strategy

A pyramiding strategy is considered a risky investment approach, but with proper money management can produce stellar results.  Recently the market has taken a hard nose dive, with little or no retracements.  If a trader was short, this kind of market environment would have been a prime candidate for a number or pyramiding strategies.  In the below chart, Citigroup took a beating from a swing high of $49 in early October to a low of $3 in November.  In a pyramiding strategy a trader will want to add to their positions on each bounce.  So, in the below example when the stock fell from $49 and then had a short rally up to $35, this would represent a 29% drop, which on margin would be a 58% gain on your cash.  This additional 29% of paper profits would then be used to add to the short position at $35 for the ride down.  This process of adding to the short position would have continued all the way down to $3.  Which would have produced much greater returns than simply shorting the stock at $45 and riding it down to $3.

Negatives of Pyramiding

Pyramiding will only work properly in a trending market.  This is because if you are trading in a choppy market, the short-term corrections will naturally float towards previous swing points, thus eating into your original gains.  So, remember to only consider such a trading strategy when both the markets and stocks are trending heavily in one direction.