What is your Style of Investing?
Buy low, sell high. This is one way to make money. This is also one style of investing. You can apply this to any asset class. A style is defined by the rules you are following in your investing strategy to generate returns over time. As you can imagine, researchers have uncovered a few time tested strategies that have worked over time. We are going to explore some of them.
The Yin and Yang of Styles
Buy low, sell high is otherwise know as the Value style. Value investors are contrarians who look for undervalued assets. They buy assets when the assets have lost value and are about to turn around. For a typical investor, it is quite frightening to put more money into a stock whose value has declined recently. They are scared that the stock might lose further and their new money will get decimated. Value investors are the brave souls who as Warren Buffet puts it "get greedy when everyone else is fearful".
The Achilles heel for value investors is valuation itself. They prefer valuing an asset on its fundamental economic characteristics. If they determine the valuation is not attractive or the current price of the asset seems overpriced, they will step away. Another set of investors may find assets that are consistently going up in price to be attractive. These are the bubble chasers or Momentum investors. It is a well known fact that financial markets are not fully efficient. That is, due to market frictions and inability to discover the fair price instantly, assets are sometimes mispriced. Thus when a news is announced about the success of a particular product launched by a company, the extent of the success is not instantly established in the price of the stock. It may take a few days to months or even years for the market to realize the full value of that success. Momentum investors ride on this wave as the price of the stock rises to realize the full extent of the success.
Value and Momentum investors can be imagined as two ends of a spectrum. Investors need not be polarized to one end however. One can enjoy the returns from Momentum and Value at the same time. It is important to assess which asset classes and within a class which specific assets are exhibiting the characteristics of Momentum or Value. An investor would use the Momentum style to invest in assets that show a strong momentum while use Value style to invest in assets that show strong value characteristics.
Carry
Carry is a trader's technical term for yield. A government bond or money saved in a money market account produces interest every year. This indicates the yield on that investment. If you have some money and are looking to put in a money market account and two different banks offer slightly different interest rates, you would go with the bank that pays the higher interest. This is the Carry style of investing. It applies to almost all classes of assets. For corporate bonds, one would consider the company that pays higher interest rate on their bonds among a set of companies that have roughly the same credit risk. For currencies, one would invest in a country that has higher real interest rate. Dividend stock investing belongs to this style. Stocks that pay higher dividends but otherwise are stable and comparable are sought after by a Carry investor.
Volatility Selling
Insurance provides real value for investors. In financial markets, there are markets for derivatives which are instruments built using more fundamental assets such as bonds and equities. Investors can provide insurance to other investors who look for protecting their investments. In the equity markets, this is achieved through options. Put options provide the put option purchaser protection from loss in an equity position. The loss is absorbed by the put option seller who is the insurance provider and collects a premium. Conversely, a call option provides the call option purchaser higher upside in case an equity position performs well. The upside is provided by the call option seller who collects a premium for writing this option. It has been observed that, by and large, there is a higher demand for these equity options than what is actually realized. This means, on an average, the insurance provider makes a positive return in options transactions. The price of an option depends heavily on the volatility of the underlying stock price. Hence this is termed as Volatility Selling style.
Understanding the various asset classes and the different styles help one capture most of the accessible returns in the financial markets.
As you work through identifying your favorite style of investing, we are here to help answer any questions you may have.