What is an investment strategy?
Looking for the investment strategy definition? An investment strategy is a term used in the financial and investing world to describe an approach to investing. Essentially, an investment strategy is a plan for selecting financial vehicles tailored to the investor’s needs and goals, in addition to their risk appetite, specific interests and time horizon.
When an investment strategy is in place, the investor is able to make better and more informed decisions about the types of investments they’d like to include in their portfolio, which is essentially a big briefcase carrying an investor’s financial assets including stocks, bonds, property and cash equivalents.
Where have you heard about an investment strategy?
An investment strategy plays a key part in portfolio management, which is a process involving deep analysis of investor goals and interests as well as market strengths, weaknesses, opportunities and threats to then tailor the perfect investment choices.
You may have also come across investment strategies if you’re part of a defined contribution workplace pension scheme. Pension schemes invest an individual’s money in things like shares, often switching to lower-risk investment strategies as they approach retirement.
What you need to know about an investment strategy.
Investment strategies differ greatly from investor to investor, with the overall target being to align the investment strategy with the investor’s goals, activity and interests. A simple and introductory example of two polar opposite types of investment strategies would be a safety approach favoured by an investor looking to protect their wealth and a rapid growth approach favoured by an investor looking for capital appreciation and high profits. Investment strategies generally involve a trade-off between risk and return.
In layman’s terms, there are three basic investing style types:
- conservative: an investor who has a risk tolerance ranging from low to moderate and wants to protect principal and earn income
- moderate: a moderate investor is willing to take more risk to achieve stock price appreciation and reasonable, but stable income and capital growth
- aggressive: an investor, at the far end of the scale, who wants to achieve high overall returns and is willing to take risks to do so
Because individual goals and interest vary so much, there are a number of different investment strategies that different individuals can choose to adopt. It is also important to state at this point that the global marketplace can be particularly daunting to individual investors. As a result of this, adopting an investing style has been a popular technique since the 1980s. This is because categorising stocks allows both institutional and individual investors to process stock information and performance more easily and efficiently. They are also able to better evaluate the performance of different money managers since money managers are generally evaluated and ranked in accordance to a performance benchmark for their style of investing.
Most investment strategies consist of asset allocation, buy and sell guidelines and risk guidelines. Asset allocation tries to achieve a balance between risk and return, operating under the principle that different assets perform differently at different times and under different market conditions. Asset allocation therefore involves adjusting the percentage of each investment asset class in a bid to maximise return for the investor’s level of risk.
Asset allocation depends on the investor’s objectives – for example, somebody looking to save and earn rewards in the short term will invest their savings conservatively in a mix of cash, short-term bonds and certificates of deposits (CDs). On the other end of the scale, somebody looking to save for retirement might choose to invest most of their retirement account into stocks knowing that they have time to ride out any market volatility. Risk tolerance also plays a huge part, as it is crucial for the investor to feel comfortable with their investment strategy.
Investors without an investing style or strategy are referred to as ‘sheep’ and those who randomly select their investments have been referred to as ‘blind-folded monkeys throwing darts’ to reflect the idea that they are essentially throwing darts at a newspaper’s financial pages.
As touched on above, all investments involve a certain degree of risk, and as a result there is a general rule that total risk should link to total return. In theory, this means that the greater the risk of the investment, the greater the expectation of return. And thus, investors taking less risk should expect less return. When making an investment choice, an investor’s risk is assessed to ensure their portfolio is carefully constructed and reflective.
A key risk management technique and one of the top recommendations and lessons in portfolio managementis to create a diversified portfolio. This approach involves building a diversified portfolio with different investments, each carrying different risk levels and yields, with the contention that over time, different investments will, on average, yield higher returns without posing too much risk to the individual.
Since most non-institutional investors have limited investment budgets however, they may find it difficult to achieve an adequately diversified portfolio. As a result, there is an increasing popularity in mutual funds, which allow investors to diversify at a low cost by paying into a pool of money supplied by different investors, which are then used by the mutual fund company to buy different stocks and bonds. Mutual fund investing requires a lot of research and a professional investment manager to ensure the right investment decisions are made.
In general, investing strategies tend to centre on either value or growth. A common investing styleis a passive investment strategy (for example, buy and hold), which aims to minimise transaction costs. Other common types of investment strategies include:
- momentum trading - which involves selecting investments based on their recent past performances.
- dividend growth investing - where an investor invests in company shares based on forecast future dividend payments.
- pairs trading - where an investor buys similar stocks and takes a linear combination of their price to achieve a stationary time series.
- contrarian investing - where an investor selects a company in a down market and purchases large quantities of shares in the company in a bid to make a long-term profit.
Over the past few decades, a number of different sub-styles have also been identified. These include deep value, relative value and new value, which were identified by Standard & Poor’s in the 1990s. The deep value style adopts the traditional Graham and Dodd approach, with money managers purchasing the cheapest stocks and holding onto these stocks for a long period of time in the hope that there will be a market upswing.
Relative value sees money managers seeking out stocks that are under-appreciated in terms of their company’s earnings potential. Relative value stocks are typically held for three to five years, with relative value managers pursuing investing opportunities across all economic sectors as opposed to concentrating on valuable sectors value. The ‘new value’ approach sees money managers selecting investments from all securities categories, specifically looking for stock promising substantial appreciation.
Find out more about an investment strategy.
Our online glossary contains a wide range of different financial definitions, including those related to investment strategies – for example, portfolio management, diversification and risk tolerance are all carefully defined and explained on our website.