There are two basic schools of thought when it comes to active investing. (Active investing is buying individual stocks and trying to beat the market. The opposite would be passive investing where one simply buys the market through mutual funds and takes whatever one is given.) The first is called momentum investing. The second is value investing. A question many investors face is which to choose.
Momentum investing is based on the idea that once a stock is moving in a given direction, it will tend to keep moving in that direction. The best momentum investors will find stocks that are starting to move early in the cycle, buy in, and then sell just as the stock starts to slow its rise. These investors are skilled at seeing trends just as they are starting. The worst momentum investors will buy the hot stocks just as they are cresting and then hold too long, resulting in a big loss.
The good thing about momentum investing is that it is generally easy to spot what to buy. Just look for the stocks that are hitting all time highs and that some people – but not all of the people – are talking about. Maybe look through publications like the Wall Street Journal or Forbes. Avoid the stocks touted in places like Money magazine or – God forbid – Time. (There is actually an investing strategy that shorts any company that makes the cover of Time since that tends to mean the stock is way too over-bought and pricey. Remember, if everyone owns it, there is no one left to buy it.)
In value investing, one looks for stocks that have been beaten down and therefore are really under-priced. The idea here is that if something is selling for a lot less than it is worth, it has to increase in price at some point. Part of value investing is determining the fair price of a stock, which is typically done by looking at things like the price earnings ratio or the price to sales ratio and comparing it to that of other, similar companies or to the historical average for the company. Value investors will load up on stocks while they are inexpensive and then sell off when they become overvalued, again based on comparisons to other stocks and the stock’s historical average.
While value investing may seem like a safe way to go, it can actually be more dangerous than momentum investing. While you take the chance of catching the wave too late with momentum investing, you are buying companies that are having problems when you do value investing. Stocks are typically low in price for a reason, and some may go out of business if they cannot get their financial houses in order. Also, value investing typically requires a lot of patience since it often takes a long time for investors to find stocks that are beaten down. If no one is buying a stock, few people are talking about it as well.
There is a third way of investing that is the typical subject of this blog. That is buying a company based on the business instead of the stock price. This involves looking for companies that have consistently growing earnings, are well run (as shown through things like low amounts of debt or no debt at all, a lot of cash flow, and management teams that are experienced and committed), and which have a lot of room for growth. At times these stocks may be riding high and attractive to momentum investors. At other times they may be beaten down and attractive to value investors.
This is a long-term strategy since price will not necessarily follow earnings growth over short periods of time. There are many factors that cause stocks to rise and fall over a period of day, weeks, or even months. Over periods of years, however, the best companies will prosper and grow, while the worst companies will falter and disappear. In good economic times, the best companies will gain a lot of customers and sell a lot of products. During downturns they will trim their size appropriately and take advantage of the failing of their less well-run competitors.
It is also much easier to spot the great companies than to predict what a stock price will do over a short period of time. They are the companies that have earnings growing year after year, which tend to have consistently increasing stock prices (when viewed from the long-term), and which have high quality products and enthusiastic customers. These are the companies that are a pleasure to deal with.
Remember that people make money using each fo the strategies outlined above. Be wary though since many people who actively trade stocks do worse than they would have if they had just bought a set of mutual funds and forgotten about them. Always remember to track your progress and review ho well you are doing periodically. It is too easy to remember a few winners and forget all of the bad purchases you have made.
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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.
Picture Credits: Pierre Amerlynck , Downloaded from stock.xchng