Three Basic Investment Strategies
What's the best way to get started with investing?
I believe that every investor needs to start by have a clear investment strategy that is tied to his/her goals. While there are certainly countless investment strategies being pursued everyday by investors, there are 3 foundational approaches that can serve as basic building blocks to achieving one's personal goals.
1. Index/Index Plus
The objective of the Index/Index Plus strategy is to essentially track or slightly outperform the returns of a broader market benchmark relevant to your portfolio (e.g. S&P 500 index, small cap index, emerging market index, etc.). This can be done by essentially building a portfolio consisting either entirely of index ETFs such as SPY or VTI which track the performance of the S&P 500/overall market index, or a portfolio comprised primarily of index ETFs with the addition of a few stocks selected based on their potential to outperform the market.
Index/Index Plus is a strategy that I think is very appropriate for beginning investors because it can be achieved largely through some simple passive investments. Additionally, given that there's lots of empirical evidence that most mutual funds do not consistently outperform the market, this is also the strategy that provides the everyday investor with the best chances of success. To underscore this point, I'll share a story that was told by one of my finance professors at Harvard, who has taught many of the mutual fund managers on Wall Street. He shared that in a workshop he once held with may of his former students who are now managers at well known actively-managed funds, he asked for a blind show of hands (with eyes closed so no one could see how others actually voted) of managers that invest their own money into an index fund like those offered by Vanguard. To his great surprise, the majority of the room had their hands raised! The lesson here is that if even the most savvy and sophisticated active-fund managers also hedge their bets with an index based strategy, then this should certainly be a strategy that individual investors need to consider.
2. Seeking Alpha
The objective of what I call the Seeking Alpha strategy is to essentially beat the market benchmarks with out-sized performance. This is essentially the strategy that most investors think of when they look to invest in the market place and is certainly what gets the most press and media attention given the celebrity of those who have been able to do this successfully - Warren Buffett and Peter Lynch come to mind here. However, this is much easier said than done. To consistently beat the market, or even do this for one year, requires a lot of hard work, accurate insights into macro economic movements or specific companies and industries, and often a fair bit of luck.
There are a wide range of ways to achieve success with a Seeking Alpha strategy but all with greater risk than simply attempting to track the market. Being successful at Seeking Alpha often means "buying low and selling high", which by definition requires contrarian thinking and behavior since buying low usually means others are selling and running out of the market. So you would have to do your home work to find deeply out-of-favor value stocks that have upside potential before the market discovers them and have the conviction to act on them. Another approach may be to rotate sectors based on your forecast of macro economic trends or to make concentrated bets in specific stocks. In other cases, some investors may employ more sophisticated strategies using options or leverage to amplify their returns, but also take greater risk in the process.
In short, this is a much more aggressive investment strategy that is probably best left for the more savvy and experienced investor who has the time and energy to devote to managing their portfolio full time.
3. Consistent Absolute Returns
A third basic foundational investment strategy is Consistent Absolute Returns. The objective of this strategy is to achieve a set percentage return on your portfolio (e,g. 5%-10%) regardless of market conditions. Investors who favor this strategy tends to be those who are interested in generating a predictable income stream from their investments, e.g. retirees. If this is your desired strategy, your investment allocations are likely to include a fair amount of cash and cash equivalents, e.g. municipal bonds, corporate bonds and bond funds, and high dividend yielding stocks. It could also include some conservative option plays designed to generate income such as covered calls. Obviously, the lower the absolute return goals, the more basic the means to achieve them, e.g. greater focus on cash.
As I've alluded to at the beginning of the article, there are certainly many variants of the above and I believe that an investor may want to have some percentage of their portfolio allocated to each of these above strategies and simply adjust the weighting amongst them as their life needs shift and their investment acumen increases. For most investors, I think having a majority of their portfolio in an Index/Index Plus strategy is a good start, and as they become gradually more knowledgeable and comfortable with taking risks, then they can slowly increase the allocation to the Seeking Alpha portion. While the Consistent Absolute Returns is a strategy that increases as the overall portfolio builds and the need for a predictable income stream grows.