investment Plan

How to Choose an Investment Strategy to Fit Your Objectives

About 8 months ago someone asked me what I would recommend she invest $100,000 that she received as an inheritance in. I often get questions about what to invest in, so I knew exactly how to respond.

Before even beginning to answer this question I make it very clear that no one knows what the market is going to do in the future. If I knew what the market, or any individual security, was going to do even one minute in advance, I’d be a very rich man. But I don’t know, which is why all I can do is to take as educated a guess as I can to decide what to do in the market.

As we’ve seen over the past year, even the largest and most successful hedge funds with the best information and most sophisticated analysis can be wiped out as a result of unforeseen events and market moves. When people ask investment professionals for stock tips, they assume that professionals have an edge. That is probably true, since the more knowledge of the market you have, the better decisions you can make and the higher the probability that you will make the right decision. But I stress the word probability, because nothing in the market is certain other than the market will do whatever it wants to regardless of what you think.

Given the uncertainty in the market, an educated investor can make good investment decisions based on an analysis and understanding of a company’s business and financials, otherwise known as Fundamental Analysis. If you invest in a company with growing revenues and profits, low debt, lots of cash and a rosy business outlook, there’s a good chance that your capital will remain in tact and hopefully grow over the years. 

Apple (AAPL) comes to mind as a good example of a company that is arguably the most financially secure and economically viable as any in the history of mankind. If you buy shares in AAPL, they will probably never go down to zero. Under normal, foreseeable circumstances, you’ll probably have a pretty good chance of seeing your shares increase in value.  Do you want that guaranteed?

No professional will ever guarantee that you’ll make money on any investment, no matter how secure it seems, for two reasons:

  1. Unexpected, extraordinary events can occur that can change everything.
    Wars, epidemics, natural disasters or new technology can disrupt markets and economics in ways that cannot be foreseen. For example, new technology might be discovered that makes iphones and Macbooks obsolete. Or a war or natural disaster might destroy all of Apple’s production capabilities, preventing the company from earning revenue for an extended period of time. 
  2. Whether you make money in Apple shares or not depends on your investment timeframe. 
    Apple might go through a period where, because of general market condition, its stock price might drop significantly. So even if the stock price bounces back at some later date, if you need your money before the bounce, you’ll end up selling at a loss.

Timeframe

That brings me to the beginning of my response to the woman who asked me where to invest.

The first question I asked her was what her timeframe was. How long did she want to invest her money for?

She said 6 months to a year.

Now we’re getting somewhere.

How you choose an investment strategy is going to depend on your timeframe. If you are looking at a 3 to 5 year plus timeframe, then you’ll want to choose your investments based on the fundamentals of the company you are looking to invest in, and you’ll ignore short term price fluctuations that are not based on any change in those fundamentals. As long as the fundamental case holds true, then temporary market downturns that negatively effect your investment value should be ignored. You’re running a marathon, not a sprint. 

What timeframe is considered long-term and what is short-term is up for interpretation. Most financial sources define short-term as less than a year and long-term for over a year. But for some investors, like Warren Buffet for example, long-term might be counted in decades. For short term traders, a month or 2 might be considered long-term. 

In the current market (Nov. 2022), with all its uncertainty and volatility, I’d say that you’d need to go out a minimum of 3 years to be able to ignore short term market volatility and focus primarily on fundamentals. 

Because of the current market craziness, I advised the woman who needed her money in six months to a year, to keep her money out of the stock market and either keep it in an interest bearing cash account or a short term CD. If she had a much longer timeframe my answer would probably be different, but given that she would need her money, in full, in less than a year, investing in the stock of even so called safe companies, like Apple, would carry the risk of her losing a substantial chunk of her capital. 

Assuming you have a long-term investment timeframe, you need to consider three factors before investing in any risk asset (stock, options, bonds etc).

  1. Risk
  2. Risk Management
  3. Risk Tolerance

Risk

Although all financial instruments carry some degree of risk, for the purposes of this discussion I’ll leave out financial instruments backed by the US federal government, state and municipal governments and banks (CDs). These, along with certain highly rated corporate bonds are practically risk free. In today’s market, these safe instruments can pay you over 5%, which is a pretty fantastic return given that your original capital is guaranteed. If you’ve got cash lying around that you don’t need day to day, you should seriously consider putting it to work for you in one of these safe investments. 

This article is focused on investing in stocks, or stock options, so risk is a key factor in any investment decision.

We’ve already established that even if you invest for the long-term in a company that has strong fundamentals, there is still a risk that the price of your investment will drop below what you paid for it. In most cases, the riskier the stock, the greater the potential return. That’s because the market has already adjusted the stock price for future earnings. 

People buy stocks for dividends, capital appreciation or a bit of both.

If you’re buying for dividends, you don’t need the stock price to increase in order to make money, although that’s always a welcome bonus. You just don’t want the stock price to drop to the point where you are losing money even after collecting the dividend. 

When you’re buying for capital appreciation you are either looking for stocks that you believe have been undervalued by the market or that have a lot of growth potential. An established company like Apple is probably pretty fairly valued by the market, so while Apple’s stock price can certainly go higher, a lot of very wonderful things would have to happen to the company and the general market for Apple stock to double in the next few years. While that might certainly happen, most Apple investors aren’t counting on that. What they are counting on is that Apple continues to grow and innovate, and that the stock price reflects that by moving higher instead of lower. And if Apple doesn’t perform as well as expected, they hope that the stock doesn’t go down too much because, at the end of the day, Apple is still one of the premier companies on the planet with hoards of cash in the bank for a rainy day. 

On the other hand, a new technology company just getting started might be seen as having tremendous potential to double or triple in price.  On the downside, however, it can also fail miserably and go out of business. So while the reward in investing in this company’s stock might be huge, the risk of losing most or all of your money is also significant. 

Perhaps the clearest example of stock risk is in the pharmaceutical sector. Let’s say theres a public company developing a new cancer drug. The stock is priced at $20. Investors in this company believe that the new drug could be worth a billion dollars in revenue and push the stock up to $100. They’re hoping for a 500% gain — not too shabby. On the flip side they recognize that the drug might turn out to be a failure, or it might not be approved by the FDA, or another competitor might bring a similar drug to market first, or something else might go wrong. In any of those scenarios there’s a good chance that the stock could go down to zero (or close to it) and the investor will lose all of his capital.  

Risk and return are two sides of the same coin because, as we discussed before, the higher the risk the higher the potential return, and vice versa.  Therefore, the first step in your investing process is to decide how much of your capital you are willing to risk to achieve the return you’re seeking. There are different ways you can scan for stocks that fit into either the high or low risk category, but how to do that is beyond the scope of this article.

Let’s assume that you’ve chosen your desired return and risk level. The next step is risk management. 

Risk Management

Managing your risk simply means taking specific actions to make sure that you don’t lose more money than you can, or are willing, to handle.

There are a few ways to do that:

Investment Selection

The most basic way to manage your investment risk is to carefully select the companies or instruments to invest in. This includes analyzing the fundamentals of the company to form an opinion of how well you believe the company will do within the timeframe you’ll be investing for.

If you’re seeking low risk, you’ll look for companies with strong financials and balance sheets that are returning capital to shareholders through dividends or stock buyback programs.

For high risk you’ll go with companies at the starting end of their journey with lots of growth potential that might be currently operated at a loss or who are in the process of developing a product or drug that could be an extraordinary success — if it comes to fruition.

Then there are all the levels in between high and low risk to select, based on your personal requirements. 

While you have no control over what the market does, you have TOTAL control over your investment selection, so make sure to choose wisely so that you take on the appropriate degree of risk that you’re prepared to take. 

Bitcoin is a great example of this. Many experienced investors invested a very small portion of their capital in Bitcoin and other crypto currencies. They kept their investments super small because of the riskiness related to any new, unproven product and the extreme volatility in its price moves. There were, of course, some big players who placed major bets on Bitcoin, but they were the minority and would not end up in the poorhouse even if they lost it all. 

Many amateur investors, however, placed HUGE bets on crypto,  relative to their net worth. Some even went all in, hoping to take Bitcoin and other coins “to the moon”. Those who got in early and then got out when Bitcoin hit a high of over $68,000 made out like bandits. But all those who bought at 20k or higher are now (11/10/2022) watching Bitcoin trade below $17,000. That’s not the worst thing if you bought at 20k — just a 15% loss. But imagine if you bought at 40k? Or 50k? Or 68k?!! Some daredevils went all in!

Clearly, the decision to invest in Bitcoin was, and is, only for those willing to take extreme risk. An investment in Coke or Pepsi isn’t going “to the moon”, but it also will let you sleep at night, knowing that your downside risk is minimal. Investing in highly rated corporate bonds or government backed securities is even safer, but fixed-income securities is beyond the scope of this article. 

We’ve focused our risk discussion on instruments that don’t expire, such as stock or crypto. But we haven’t touched on options — contracts which convey to its holder, the right to buy or sell a specific quantity of an underlying asset or instrument at a specified strike price on or before a specified date. We’ll talk a little more about options later in this article and we’ll dive in depth in a separate article.

For right now all you need to know is that options can be used to bet on the direction of a stock (or crypto or futures) move for a fraction of the cost of buying the actual stock or asset. The catch is that an options contract comes with a time limit. You can buy as much time as someone is willing to give you, but you will be paying a premium based on the length of the option. But if your desired move doesn’t occur by the date of expiration, you lose your entire investment in that option. Also, the value of you option will decrease each day, since part of the price of that option is its time value. So even if the stock moves in the “right” direction before your option expires, you might still end up losing money if it took too long to happen.

The positive aspect of options regarding risk is that you can only lose the price that you paid for the option, which is usually only a small fraction of the price of the underlying stock. So you know exactly what you are risking from the start. If you want to bet on the movement of a stock (wither up or down) by putting up a relatively small investment, which you are willing to lose, then options are the right tool for you. Just remember that time is working against you, so not only do you need to be right about the direction of the stock movement, you also have to get the timing just right. 

Bottom Line: What you choose to invest in must be based on the risk you are willing to take.  

Diversification

Another popular way of managing your risk is to diversify your investment portfolio. In plain English — “Don’t put all your eggs in one basket.”

Investing 100% of your capital in one stock ties your financial to to that stock. If it’s a risky stock, like Tesla, well…get ready for the roller coaster ride of your life. But even putting all of your money in a safe stock like Coke could be dangerous in the event that something unexpectedly happens that adversely effects the company. What happens if Congress one day passes a law against all carbonated drinks? Very unlikely — but if it did happen, your capital would probably take a large hit. 

Diversification would advise you to spread your capital among several stocks in different sectors so that if one company or sector takes a hit, you won’t be to greatly affected. For example you might allocate your investment between Microsoft, Coke, Pfizer, Caterpillar, Chevron, Disney, McDonalds, JPMorgan (these are no recommendations, just examples of major companies in different sectors). You might throw in a bit of risk, like some Tesla or Snowflake. Or you might just invest in different sector ETF’s, so you don’t have to pick individual stocks. How you allocate your capital will be based on your personal risk profile and investment objectives. 

Even in the event of a totally unexpected global disaster (natural, war, financial) that brings down the entire market, diversification will still offer you some protection in mitigating your losses. 

Bottom Line: Diversification in the allocation of your capital can help minimize your risk. 

Timing the Market

When you decide to invest could play a major factor in the risk you undertake. Timing the market is one of the most difficult things to do successfully, which is why most investors, including many professionals, just allocate capital in a consistent fashion instead of waiting for what they might think is the exact right moment.

The problem with timing the market is that if you get the timing wrong, you could either miss out on a massive rally or get in right before a massive crash. On the other hand, the historical stats show that if you keep your money in the market for the long-term, you WILL make money. That means that you need to hold on to your investments through major down turns and that you won’t need to withdraw your money for personal emergencies or life events. If you take your money out at the wrong time, those winning stats go out the window. 

But if you have some capital that you want to invest at the “right time”, you should consider trying to buy good companies when they’re down. Just because a stock is cheap is not a reason to buy it. A cheap stock price could get much cheaper if the underlying company is not performing or in trouble. But when a company that is performing well gets cheaper because of the sector that it’s part of or because of an overall market downturn, that’s an opportunity to buy on sale.

Think Apple, Microsoft and Google. They are all companies that are wildly successful in making money, and have business that seemingly can’t be stopped. When these companies (and others like them) drop 20%, and you believe that their business prospects and fundamental are still solid, then it might be the perfect time to start buying. On the other hand, when the market looks like it’s “going to the moon” for seemingly no good reason, it might be better to sit back and watch a bit to see if things calm down a bit. Everyone would rather buy on sale than pay full price, right?

But what if the bottom or top of the market isn’t so clear (it never is)? 

What if you don’t want to miss out on a hot stock, or if you’re afraid to get in because it might go even lower?

That where position sizing and scaling come in to play.

Position Sizing and Scaling

Size might not be everything, but it is a major component of risk management. Getting back to the Bitcoin example, let’s say you invested $1,000 and it’s now worth $500. That’s a 50% loss, which is huge, but in real dollar terms, mist people aren’t going to the poorhouse for losing $500. Assuming that $1,000 want’ your entire net worth, you probably decided to manage your risk by only making a very small investment in Bitcoin. But if you’re entire account was $10,000 and you put half of it into Bitcoin, that’s a significant loss that could materially affect your life. 

Everyone is going to have different sizing parameters based on the size of their capital account. A large hedge fund managing billions of dollars might have lost $25 million in Bitcoin that mean nothing to them because it’s such a tiny percentage of their capital. 

Part of risk management is to decide how much of your capital to put at risk. The more confident you are about a certain stock, the more capital you might decide to risk. If you’re feeling unsure and the risk seems high but you don’t want to miss out on a potential opportunity, you can participate by sizing down your investment to mitigate your risk. 

For example, you’ve got $10k to invest and you notice that Apple is trading at 140, down from 170 just a few weeks ago. You love the company fundamentals and believe in its future growth. You also know there’s a chance that the stock can go down to 125 easy (and lower). If you want to buy, consider buying a quarter or a half of your position and then see what Apple does. If the stock drops to 125 you can buy more — scaling in. If the stock goes up you’ve made some money and can decide if you want to scale in at the slightly higher price.  Scaling is not buying or selling everything at once. 

Sure, buying a full position with your 10k seems really good if the stock goes up — not so smart if it goes down. Hence, position size to manage your risk!

Hedging

Hedging is used extensively by professionals — like HEDGE funds — but not so much by ordinary investors. Although diversification and position sizing are forms of hedging, the hedging strategies used by the pros usually revolve around taking positions, in stocks or options, that should move conversely to the positions they are looking to protect. For example, you might protect a large Apple stock position by buying some cheap Apple put options. You might protect an entire portfolio of S&P 500 stocks by shorting or buying puts on the S&P index or ETF (SPY). 

If not executed properly, hedging can end up significantly degrading your overall return or even losing you more money than you would have without the hedge, which is why most average investors don’t use them. 

Risk Tolerance

Now that we’ve discussed the elements that go into Risk Management, we need to spend a bit of time on something that can’t be easily quantified: Risk Tolerance. 

There are models and formulas out there that can quantify how much risk exists in a particular investment or investing strategy. And there are specific, quantifiable steps you can take to manage and mitigate that risk (as we’ve just discussed). 

But there’s a part to investing that can’t be expressed in numbers or formulas, and is unique to each investor: Risk Tolerance. How much of a loss can you stomach before giving up and selling?

It’s easy to say that since you’re investing for the long term, short term fluctuations in the market won’t bother you. But a year or two into your plan, when you check your account and see that it’s 30% down, are you still going to be ok about holding? 

Statistics might be telling you to hold, but basic human psychology and emotions will be screaming for you to sell and protect your capital, your retirement…your future. 

Even with all the risk management you can implement, you still have to take your personal risk tolerance into account when choosing where to invest your capital. Investing in volatile stocks might have the potential of giving you outsized returns, but if you can’t handle significant losses, even if they are only temporary, you need to focus on less volatile stocks that will give you a more modest return but will allow you to sleep at night. 

Long term investors end up losing money when they see losses and sell out of fear instead of staying loyal to their long term plan and holding. 

Bottom Line: Before you invest, know your own risk tolerance and choose your investments based on the degree of volatility that you can handle. 

In Conclusion

Investing in the stock market is hard. 

If you decide to invest your capital in the market, here are some things to keep in mind:

  1. Choose your investment timeframe.
  2. Devise a strategy based on that timeframe.
  3. Understand the risk inherent in your investments.
  4. Manage your risk.
  5. Manage your emotions.

Most importantly, if you need your money to pay bills or make specific purchases (like a house, car, vacation, tuition, wedding etc), consider investing it in risk free instruments like government bonds or certificates of deposit — or just keep it in your bank account. You might not make a lot on it, but at least you’ll be sure to have it when you need it. 

Best of luck!

 

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