As Canadians endure an unprecedented period of change, people across the country may be paying more attention than usual to their personal finances. Some—especially younger people and frontline workers—are struggling with ongoing unemployment, lost income and rising debt. But those fortunate enough to have uninterrupted sources of income and jobs have likely seen their savings increase. Regardless, many Canadians don’t think much about how they should invest.
How quickly people recover financially from the crisis—or lose the gains they made—may depend on how they invest. Gaining a fundamental understanding of the most popular investment styles is one of the best ways to make sense of the thousands of investment options in the market today.
Which Investing Style Is Right for You?
Today there are thousands of investment styles, and every investor may have a unique strategy that works for them. What works for you depends on such considerations as whether are you a risk-taker or risk-averse, whether your investment goals are long-term or short-term, whether you want to invest on your own or hire an investment advisor.
What Is Your Investing Style?
Having a basic understanding of fundamental investment styles helps you make sense of the many investment options that are available.
1. Time Horizon versus Risk Tolerance
Your tolerance for risk pertains to how much volatility in the stock market you are willing to accept in exchange for potential long-term growth. Your time horizon is the number of years during which you can contribute to your investment account before using part or all of the money you have invested.
If you are risk-averse, you can easily suffer losses by selling investments at the slightest sign of volatility. So carefully consider the level of market risk you can tolerate and how that level affects your investment goals. Also relevant is your capacity to bear risk. What is your financial ability to weather declines in your investment account? If you have emergency savings sufficient to pay your bills for six months, your ability to bear risk is greater than it is when you have no emergency savings.
How much time you can give to your investments depends on your investment goals, how much risk you can accept, and your ability to recover from declines in the market. If your investment horizon allows you to wait for long-time returns from riskier assets, and you have the emotional discipline to accept short-term volatility, you can consider more aggressive mixes of assets when investing.
2. Active Investing versus Passive Investing
If you have a high tolerance for risk and the ability and temperament to cope with market dynamics, an active investing style may be for you. Active investing is a popular style with investors who are more focused on the short term than the long term. When you invest actively, you select specific stocks and exploit market timing in hopes of gaining short-term profits and outperforming the market. If you adopt this style, avoid the temptation to chase returns based on such dubious assumptions as that a stock or other investment that has recently performed well must continue to do so. As the saying goes, past performance is no guarantee of future results.
Active investors may engage the services of professional money managers to carefully select their stocks and actively manage their funds. Actively managed funds are typically run by a full-time staff of financial researchers and portfolio managers who are constantly on the lookout for large returns. Since you must pay for this expertise, actively managed funds charge higher fees than passively managed funds.
Passive investing works better if you are risk-averse, have trouble coping with market dynamics, and have an eye on the long term when you invest. Instead of timing the market, as a passive investor you may create a portfolio that tracks market-weighted indexes. The diversification lowers your risk, and the low turnover lowers your transaction costs.
Over time, passive investment often yields better returns than active investment, in part because it does not rely on the services of experts and therefore incurs relatively low expenses. But whether you invest passively or actively should primarily depend on your investment goals.
3. Value Investing versus Growth Investing
Also consider whether you want to invest in fast-growing companies or in underpriced industry leaders. To determine which category a company belongs to, experts analyze certain financial metrics. Investing in either kind of company can be growth-based or value-based.
Growth investing focuses on companies with faster-growing earnings, higher return on equity, higher profit margins, and lower dividend yields than other those of other companies. The stocks of these companies are considered to be overvalued, have a high price-to-earnings ratio, and are expected to continue to grow in value. A company with such a stock is assumed to be an innovator that is making a lot of money. It reinvests most or all of its earnings to promote further growth. These stocks typically pay low dividends or no dividend at all, but they often make up for this by strong performance that leads to growth in the value of the stock.
Unlike growth investors, value investors look for undervalued stocks. They buy stock in a solid firm at a fair price. Value investors look for a low price-to-earnings ratio, low price-to-sales ratio, and a high dividend yield. Expecting these securities to rise in value over time, the value investor buys them before they do so. This is an investment style popularized by investor Warren Buffet, who suggests that when you buy stocks that sell for less than their intrinsic value, they will often deliver consistent returns.
4. Mutual Funds versus ETFs
Mutual funds and exchange-traded funds (ETFs) are both forms of pooled-fund investing, which bundles stocks to offer investors the benefit of a diverse portfolio.
Mutual funds include a wide variety of actively managed funds. But with their share classes and fees, the structure of mutual funds is more complicated than that of ETFs. When you invest in a mutual fund, you transact with the company that manages that fund. You buy the mutual fund for the price of its net asset value at the close of the trading day (or at the close of the next day if your order comes in after markets close). Like ETFs, mutual funds may track indexes. But the people who manage mutual funds use a variety of stocks to try to beat the index against which they judge performance. This active management makes it expensive to run a mutual fund and expensive to own.
ETFs track market indexes. This means that they try to match the returns and price movements of an index with a portfolio that matches the constituents of the index as closely as possible. ETFs trade on exchanges, and they trade throughout the trading day. At any point during the trading session, you can buy or sell an ETF at the current price as determined by market conditions. Because they are passively managed, ETFs are cheaper than mutual funds.
Since ETF providers want the price of an ETF to match the net asset value of the index as closely as possible, they adjust the supply of shares through the creation of new shares or redemption of older shares. If an ETF price is too high, the provider expands the supply to bring the price down. This can all be conveniently done using a computer program.
The structure of an ETF also enables greater tax efficiency. Both ETFs and mutual funds are taxed every year in accordance with the gains and losses incurred within the portfolio. But because ETFs engage in fewer activities, they have fewer taxable events, and you will be taxed only if you sell your shares. Mutual funds have built-in taxable gains. If you plan to sell the funds and move to EFTs, remember that taxes on capital gains may be imposed, and take this cost into account before you make the switch.
Carefully consider the long-term benefits of each of these two kinds of investments before choosing whether to invest in mutual funds, ETFs, or both.
Which Style Should You Choose?
Investing is one way to achieve your financial goals. But you must decide what to invest in. Think carefully about each of the investment styles to determine which one is right for you. A clearly defined investment style helps you select investments appropriate to your financial needs and to feel comfortable with these investments over the long run. If you’re still uncertain about how to proceed, consider engaging professional services. At MoneyWizard.ca, we will help you choose an investment style that works for you.