Investment styles: what they are and which one you should choose
An investment style is the method an investor applies to choose investments. Different investment styles change the risk profile of a portfolio, so choose carefully. Learn about investment styles and which one is right for you.
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What is an investment style?
An investment style is the approach and methodology used by an investor to choose investments for a portfolio. There are several investment styles, and each has its own unique characteristics. You can use a combination of these to create a portfolio to suit your risk tolerance and investment objectives.
Investment styles: all you need to know
There's a wide variety of investment styles, so finding one that best suits your requirements is a good place to start. This will largely depend on your risk tolerance, as different investment styles produce different levels of risk in a portfolio.
Investment styles can be broken down in a number of ways, with growth, value, quality and momentum being four of the most well-known options.¹
Investing for growth involves buying stocks expected to experience strong profit growth. Value investing focuses on companies that are undervalued but expected to rise to their true value. Quality is an investment style that looks to identify high-quality businesses expected to perform well in all market conditions. Finally, momentum is a trend-following strategy by which one buys stocks with positive momentum and sells stocks with downward momentum.
Other important style factors that impact the risk profile of an investment portfolio include a passive or active approach and market capitalisation. Passive investing has less risk than active investing because its mandate is to track the performance of an index. Market capitalisation is important, as large-cap stocks are considered to be less risky and less volatile than mid-cap or small-cap stocks.
All investment styles carry different risks and none are guaranteed to make money. For example, growth investing may fail to work if the expected strong growth fails to materialise. A key risk in value investing is if the stock becomes even "cheaper" and turns into a value trap. Momentum investing can fail to work if the market changes rapidly in direction several times, preventing momentum in either direction to take hold. Finally, quality as a style's shortcoming could be that the rationale for the initial investment changes but the investor fails to correctly spot the significance of the news and fails to sell the position.
Different types of investment styles
Active vs passive investment styles
Active investing involves a 'hands-on' approach. It requires the investor or portfolio manager to actively manage the investment choices. The primary aim of active investing is to beat the average returns of index investing by taking advantage of short-term fluctuations in share prices and choosing shares that outperform the benchmarked index.
Passive investing is a 'buy-and-hold' strategy. The standard model of passive investing is to buy an index fund that tracks one of the major indices, such as the S&P 500 or FTSE 100. Passive investing can be lower risk than active investing as passive investing closely follows the set benchmark, but may offer fewer rewards for those with a higher risk appetite. Active investing is riskier as the fees charged by managers are higher than those for passive investing and as their aim is to outperform the benchmark, managers have to take on more risk to try to achieve that outperformance.
Small-cap vs large-cap investing
Small-cap vs large-cap refers to companies with different market capitalisations. Investing in small caps is considered to be higher risk as their returns are more volatile, but can produce greater returns or losses. Small-caps investing is an aggressive investment style. This is due to the fact that they're more sensitive to market changes and normally have less access to investment capital.
Investing in large caps – companies with a market cap greater than $10 billion – is considered to be a more conservative investment style and is less risky than investing in small caps. Large-cap shares experience lower volatility in their share prices, so they provide more stability to a portfolio. They typically hold high market shares in their respective markets and have a well-established reputation with customers.
Growth vs value investing
Growth investing focuses on companies that have high future growth potential. They're expected to grow at a faster rate than their industry or the market average. Small-cap stocks, which usually experience higher growth rates than large-cap stocks, can be popular investments for growth investors. However, higher potential returns carry higher risk, so growth investing is considered more suitable for investors with a higher risk profile.
On the other hand, value investing focuses on companies that are undervalued currently but expected to rise to their true value in the future. Value investors use fundamental analysis to identify cheap stocks and buy them as long-term investments. A wide variety of valuation metrics can be used, including the price-to-book ratio, a price-to-earnings (P/E) ratio and free cash flow. This type of investing is considered to be less risky than growth investing.
Quality investing focuses on identifying high-quality companies that can perform well in all market conditions. These companies are likely to be well-established businesses with strong management, a unique business model, reliable products or a well-known brand.
Fundamental analysis is key to identifying quality companies. They normally have characteristics such as a high return on capital employed, earnings stability, a strong balance sheet and strong free cash flow generation. This style of investing is considered to be appropriate for investors with a medium-risk profile and a long-term investment horizon.
Momentum investing is a style that involves investing in securities that have recently shown momentum.
Price momentum is the most well-known momentum investing strategy. It's based on the belief that once a security has shown price momentum, it will continue to trade in the same direction in the near future. This strategy depends purely on technical analysis and uses technical indicators like trend lines, moving averages, MACD and RSI to determine entry and exit points. Once the momentum seems to be reversing, traders exit their positions, hopefully at a profit.
Earnings momentum is another type of momentum strategy. Traders monitor earnings momentum by tracking earnings releases to identify trading opportunities. When the earnings per share growth (EPS) is accelerating, traders buy the stock and hold it until the EPS growth slows down. This strategy is more suitable for investors with a higher risk profile, as there's usually a significant increase in volatility in share prices when earnings are released.
An analyst's momentum strategy is based on the recommendations of financial analysts. The strategy follows the principle that positive momentum in the share price will follow a positive analyst recommendation. Traders may look at the number of positive analyst ratings and the size of the gap to the consensus target price to help identify potential investments. They may also use other financial analyses.
Index investing is a passive investment strategy that attempts to track returns similar to a specific market index, like the S&P 500 or FTSE 100. This is done by buying the components of that index or buying an ETF that tracks the underlying index. Research has shown that over a long time frame, index investing tends to outperform active investment styles. It's a low-cost approach, too, as the management fees charged are lower than those for active investment strategies. Plus, there are fewer trading expenses due to its buy-and-hold approach.
Buy-and-hold investing is a strategy in which an investor buys a stock and holds it for a long period, regardless of market volatility. It focuses on expectations for the company's performance over the long term and is not concerned by any short-term share price movement. The aim of buy-and-hold investing is to generate long-term capital appreciation and income. This style avoids the transaction costs that may happen with a more active strategy.
Risk-based investment styles
If you have a conservative investment approach or low-risk tolerance, your portfolio is likely to focus on income and fixed-income investments that include money market and bond funds. The focus will be trying to preserve capital and aiming to provide a steady and stable income stream, which can be either distributed as income or reinvested for further capital growth. Still, even conservative styles carry risks and can lose money.
With a moderate investment approach, you have some appetite for risk and your portfolio is likely to have an equal mix of stocks and bonds. The stocks are likely to be focused on large-cap blue chip stocks with a more value-based style. This approach aims to produce moderate returns. A moderate approach also carries the risk of losing money as stocks, even blue-chip ones, and bonds can both fall in value.
If you have an aggressive investment style, you have a high risk tolerance and your portfolio focuses on stocks aimed at achieving above-market returns. The portfolio likely has a higher weighting to growth funds and potentially small-cap companies that offer higher returns but also carry increased risks.
Conservative, moderate and aggressive styles of investing all carry the risk of losing money. Theoretically, the more aggressive the investment approach, the greater the risk. You should carefully consider how much money you're willing to potentially lose before you enter any strategy.
How to choose the best investment style with us
- Do your research and decide what type of investment style suits you
- Create your live account or practise with a demo account
- Choose one of our Smart Portfolios, which are managed for you, or a share dealing account if you prefer a hands-on approach
- If you choose a share dealing account, make sure you do further research on how to diversify your portfolio and manage your risk
- If you choose one of our Smart Portfolios, we'll ask you some questions about your risk tolerance
- You can set up an Individual Savings Account (ISA) with us via your share dealing account or Smart Portfolio
- Invest a lump sum and/or set up a regular instalment to fund your account
Remember, past performance is no indicator of future returns.
Investment styles summed up
- An investment style is an approach or methodology used by an investor to choose investments for a portfolio
- Growth, value, quality and momentum are four core investment styles
- Different investment styles change the risk profile of a portfolio. It's important to choose a style that fits your risk profile and meets your long-term investment objectives
- A passive or active approach is a key decision you need to make when choosing your investment style
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