When talking to panicked investors recently (they are not my clients), I was reminded that one needs to have a strategy before buying an investment like stocks, ETFs, or mutual funds. This strategy should include actionable rules for both entry and exit. There are three main types of strategies deployed in stock market investing. We will look at each of them here.
The first is “Buy and Hold”. As the name implies, the investor buys the stock or fund for the long term. Selling the investment is not part of the strategy. Buy and Hold only works if the company / fund doesn’t go out of business, or the investor never needs the money. Its an out of sight, out of mind mentality if one uses this strategy. The investor relies on luck here because the investor never manages the position or looks for a good time to sell. The future value of the investment is completely up to chance. Either the company will still be around decades from now or it will have gone out of business.
A strategy used by many financial advisers is termed “Strategic” asset allocation. In this technique, the portfolio of stocks and funds is allocated to broad categories on a percentage basis. A typical allocation is the “60/40” you have probably heard about. When the percentages get out of line with the desired levels, the now overweight portfolio components are sold and the proceeds are used to purchase shares of the portfolio components that are below the desired percentage. This technique of buying and selling is called re-balancing a portfolio. It is done on a predetermined schedule such as monthly, quarterly or annually. Although trades are made during these re-balancing occurrences, this asset management strategy is classified as passive portfolio management.
The final strategy discussed here is active management. In this strategy, the investor wants to own only those components of a diversified portfolio that are going up at the moment. This active strategy is sometimes referred to as trend following. The concept is for the investor to wait for a signal (usually from a stock chart) to buy, let the trend run its course, and when the stock or fund price turns lower, a specific criteria is triggered that causes the stock or fund to be sold. The investor is not predicting and buying what he/she thinks will go up, but rather waiting to see what is going up. The investor owns the stock or fund for the bulk of the move and gets out when prices starts to fall.
All three of these strategies have the potential to work. Each of these strategies fits with your personality to various degrees. Before you purchase a stock or fund, you should choose your strategy. Without knowing what your strategy is, you will find it hard to make confident decisions when the markets go against you. In a future post we will look at an example of what happens when one isn’t sure of their strategy.