Whether it's for retirement, estate, or education planning, you—or your Certified Financial Planner®—should take a defined approach to investing. Investment strategies can differ per individual based on factors such as long-term goals and risk tolerance. Some strategies are aggressive and come with considerable risk, while others can be low risk but offer consistent yet limited long-term growth.
The most important aspect when developing an investment strategy is to set clear and defined goals. Figure out your main purpose for investing and think about what level of risk you might need to take on to achieve that goal. For instance, if you're saving for your child's education fund, determine how much money you need, how long you would have to invest, and a realistic annual return you would require to reach that figure.
Read on for five different approaches to take when investing:
1. Value Investing
Value investing can best be compared to bargain shopping and, similarly, it requires a considerable amount of patience. Popularized by Warren Buffet, the strategy is based on the belief there is a sense of irrationality in the market, and it involves seeking out stocks you feel are undervalued but have growth potential. You purchase these stocks with the intent of holding them until you can make a significant profit.
Traditional value investing requires a lot of time and research to find undervalued, high-growth-potential stocks. However, those without the necessary time or resources can purchase a basket of stocks perceived to be undervalued through value mutual funds such as the Russell 1000 Value Index.
While it isn't uncommon for investors to alter approaches, doing so can be particularly costly when utilizing a value investing strategy. According to Wall Street Journal reporter Jason Zweig, large stock value funds returned 6.7 percent per year from 2000 to December 31, 2009, but the average investor earned just 5.5 percent annually. This is due to some becoming impatient and pulling their money.
An additional study from Dodge & Cox highlights the effectiveness and importance of patience in a value investing approach. The authors of the study found that value strategies outperformed growth strategies in six of the prior nine 10-year periods ending in 2014-15.
2. Growth Investing
Growth investing shares similarities with value investing, but it isn't as focused on finding low-cost deals. Rather, growth investors look for stocks with high-earning potential and take into account factors such as the stock's current health and the prospects of its industry. For instance, if you believe electric vehicles could one day come ubiquitous, you might invest heavily in a company that produces electric vehicles.
While there are some drawbacks in growth investing compared to value investing, it is often more effective in the short term so long as investors have a knack for determining when high-growth "sub-periods" occur. Recent returns from growth and value strategies indicate that a growth strategy might be the more effective approach during years in which the gross domestic product is decreasing.
3. Income Investing
Income investing is relatively low risk compared to growth and value investing. This strategy is typically implemented by those who are looking to create a cash-generating portfolio to pay bills and provide living expenses beyond retirement. An income investing portfolio usually includes exchange-traded funds (ETFs), real estate investment trusts, and dividend-paying stocks. A large portion of an income investing portfolio should also be designated for bonds, which have a lower return potential than stocks but won't fluctuate as much.
4. Dollar-Cost Averaging
A method that allows investors to reduce the impact of stock volatility, dollar-cost averaging (DCA) involves periodic purchases of a specific asset at regular intervals. Also referred to as the constant dollar plan, this strategy frees the investor from the responsibility of monitoring the market to determine the best time to purchase equities. To implement a DCA approach, you need to settle on the amount you wish to invest, the time you intend to invest, and the frequency of purchases.
The DCA strategy is used in 401(k) plans and is the most effective approach for those who are inexperienced at trading ETFs. While a 2012 Vanguard study found the approach to underperform, on average, compared to lump-sum investments, it also lauded it for its relatively low risk level: "[I]f the investor is primarily concerned with minimizing downside risk and potential feelings of regret (resulting from lump-sum investing immediately before a market downturn), then DCA may be of use."
5. Socially Responsible Investing
Socially responsible investing allows you to align your investments with your values while still working toward achieving your financial goals. While this can focus on sustainable companies that seek to improve the environment, it can also emphasize socially responsible companies (i.e., companies that have a high environmental, social, and governance (ESG) score relative to their peers). Investors can also adopt a socially responsible investing approach with a negative screen to avoid products or services that have a damaging impact on society.