There is no one best investing strategy that works for everyone. Every strategy is unique because every investor has a different appetite for risk.
Some people are conservative when it comes to investing in stocks. They wait for stock prices to fall before they start investing. Some are aggressive. They buy when stocks are surging to all-time high prices.
Whatever your investing personality is, your strategy will always relate to your risk and reward profile. How much risk are you willing to take in order to make money?
Sometimes it may be difficult to make an investment decision if you don’t know your risk and reward profile. You must connect your investment personality to your strategy.
In order to have a consistent investment strategy, you must have a set of core beliefs, something like an investment ideology that can guide you in making decisions. Without it, you may easily be persuaded by any pretender or so-called market experts to buy certain stocks.
Your investments should be anchored on rock solid convictions rather than on hope that the recommendations given to you are correct. When you make your decisions out of a disciplined investment philosophy, you can always generate a back-up strategy that is consistent with your belief when you make the wrong call.
Here are the five basic investing strategies that any investor can follow:
1. Invest when stocks are fundamentally cheap
The most common investing approach is to buy stocks that are considered cheap based on relative pricing multiples such as price-to-earnings (P/E). P/E ratios are computed by dividing the market price of a stock by its corresponding earnings per share.
Take the case of First Philippine Holdings (FPH), which has a P/E ratio of only 3.98x. The P/E is computed by dividing its current share price of Php62.10 by its earnings per share of Php15.58. At P/E ratio of 3.98 compared to market average P/E of 20x, FPH is one of the cheapest stocks in the market today.
If your investing style is more on finding undervalued stocks, you can use pricing multiples to screen potential stocks for value investing. Once you have selected the candidates, validate them by checking their financial and company outlook to find out if they are worth investing.
Note that not all stocks with low P/E ratios are good investments. There are reasons why stocks sometimes trade at such low valuation. One reason may be the company could be problematic or management commitment to deliver its promises may be doubtful.
2. Invest when stocks have great growth prospects
If your investing style is to look for promising stocks that will become the next Ayala Land or SM Prime, you must look for stocks that have great growth prospects.
These stocks normally trade at high P/E ratios because of hyper earnings growth. Your focus as an investor is to look for stocks that build new assets, rather than the assets that are already in place, to grow the business.
Initial public offerings (IPO) are examples of growth stocks because they tend to promise aggressive earnings growth in the future from their new investments. High growth IPOs come with small market capitalizations that grow in size over time.
One example of a growth stock that has become a successful IPO is DoubleDragon Properties (DD), which currently trades at 151x P/E ratio. Investors buy this stock because of the prospects that earnings of the company will grow strongly in the coming years.
While small stocks are seen as growth stocks, there are mature stocks that are perceived to have high earnings prospects because of their constant investments for the future. Some of these include Jollibee (JFC), which trades at 40x P/E, Ayala Land at 28x P/E and SM Prime at 40x P/E.
3. Invest when stocks pay good dividends
If your investing style is simply to receive a steady stream of income every year similar to earning regular interest income from the bank, then you should aim for stocks that have high dividend yield. Dividend yield is computed by dividing annual dividends by current share price.
Stocks that pay regular dividends are normally established companies that have already reached a certain size and no longer pursuing higher levels of growth. These companies distribute the excess cash from earnings to shareholders as dividends.
An example of income stocks is Meralco (MER), which currently has a dividend yield of 6.3 percent. The company regularly pays around Php15 per share annually, so if you buy the stock at a lower share price, you can earn a dividend yield of as much as eight percent.
4. Invest by following market trends
Analyzing price patterns in stock charts assumes that what happened in the past can happen again in the future. The price patterns reflect how the market feels about the future of a stock.
You can buy stocks based on trends. In charting, trend lines are essential in identifying whether a stock is on upward or downward trend. Trend lines are drawn by connecting two or more historical price points and extending that into the future. For as long as the stock moves along the line, the trend remains intact.
These trend lines also serve as support and resistance. If a stock is on uptrend, the line holding the price points is called support; if the stock is on downtrend, the trend line above it is called resistance.
When a stock breaks resistance or support, a shift in trend can be expected. Trend signals change depending on demand and supply for a stock. If a stock breaks a resistance, it means the stock is a buy while when a stock breaks down from support, it means the stock is a sell.
5. Invest by going against market trend
If you are the type of investor who does not follow market consensus and likes to bet on stocks that have gone out of favor, your investment style must be contrarian.
Contrarians like to buy stocks when everybody is selling and sell when everyone is buying. While this strategy may prove to be lucrative if the investment is right, the risks of buying the wrong stock at the wrong time are high, which can lead to huge losses.
This strategy is reserved for professional traders and investors who have the skills and information to speculate and take advantage of the market situation of a stock.
Henry Ong, RFP, is president of Business Sense Financial Advisors. Email Henry for business advice firstname.lastname@example.org or follow him on Twitter @henryong888