The creation and management of investment portfolios in a stock market is a major challenge in the financial arena. Indeed, many agents such as individual investors (Jacobs, Müller, & Weber, 2014) and pension funds or life insurance companies (Jablonskien˙e, 2013) seek to efficiently manage their investment portfolios. As the stock market accounts for most of the risky assets, prediction of stock markets is crucial. However, betting on the direction of stock markets is regarded as a high-risk strategy because there are too many external factors affecting it. But, this strategy could significantly influence portfolio returns with only a slight change in proportion of allocation of assets owing to high volatility. Therefore, establishing a strategy for assigning weights to stocks is crucial for portfolio returns in asset management fields. Since years, many investment strategies are offered to adjust and attain the optimal proportions of stocks weight in terms of investment return (Morgan, 2014).
Investment
Strategies: Different methods similar goals
Teylor (2020) proposes five
common investing strategies that is adopted by and suit to most investors.
By taking the time to understand the characteristics of each, investor will be
in a better position to choose one that’s right for him/her over the long-term
without the need to incur the expense of changing course.
Strategy 1: Value Investing
Strategy 2: Growth Investing
Strategy 3: Momentum Investing
Strategy 4: Dollar-Cost Averaging
Strategy 5: Contrarian Investment
Strategy
Strategy 1: Value
Investing
Value investors are bargain
shoppers. They seek stocks they believe are undervalued. They look for stocks
with prices they believe don’t fully reflect the intrinsic value of the
security. Value investing is predicated, in part, on the idea that some degree
of irrationality exists in the market (Barberis & Shleifer; 2003). This
irrationality, in theory, presents opportunities to get a stock at a discounted
price and make money from it.
It’s
not necessary for value investors to comb through volumes of financial data to
find deals. Thousands of value mutual funds give investors the
chance to own a basket of stocks thought to be undervalued. As discussed, investors can change strategies
anytime but doing so, especially as a value investor, can be costly. Despite
this, many investors give up on the strategy after a few poor-performing years.
Wall Street Journal reporter Jason Zweig (2014) explained, “Over the decade
ended December 31, value funds specializing in large stocks returned an average
of 6.7% annually. But the typical investor in those funds earned just 5.5%
annually.” Why did this happen? Because too many investors decided to pull
their money out and run. The lesson here is that in order to make value
investing work, investor must play the long game. People often cite legendary
investor Warren Buffet as the epitome of a value investor. He does
his homework, sometimes for years. But when he’s ready, he goes all in and is
committed for the long-term (Warren Buffet: The Ultimate Value Investor)
Value Investing Tools
For those who don’t have
time to perform exhaustive research, the price-earnings ratio (P/E)
has become the primary tool for quickly identifying undervalued or cheap stocks
(Penman & Reggiani, 2018). A lower P/E ratio signifies you’re paying
less per $1 of current earnings. Value investors seek companies with a low P/E
ratio. While using the P/E ratio is a good start, some experts warn this
measurement alone is not enough to make the strategy work. Research published
in the Financial Analysts Journal (Penman & Reggiani, 2018)
determined that “Quantitative investment strategies based on such ratios are
not good substitutes for value-investing strategies that use a comprehensive
approach in identifying underpriced securities.” The reason, according to
their work, is that investors are often lured by low P/E ratio stocks based on
temporarily inflated accounting numbers. This results in a “reversion
to the mean.” The P/E ratio goes up and the value the investor pursued is gone.
If using the P/E ratio
alone is flawed, what should an investor do to find true value stocks? Dimmock,
et. al (2016) suggest, “Quantitative approaches to detecting these
distortions—such as combining formulaic value with momentum, quality and
profitability measures—can help in avoiding these ‘value traps.’”
Fig.1. Rolling 10-Year Total Return
Difference: Value vs. Growth (Source:
Dodge & Cox, 2016)
The
study by Dodge & Cox (2016) determined that value strategies nearly always
outperform growth strategies “over horizons of a decade or more.” The study
goes on to explain that value strategies have underperformed growth strategies
for a 10-year period in just three periods over the last 90 years. Those
periods were the Great Depression (1929-1939/40), the Technology
Stock Bubble (1989-1999) and the period 2004-2014/15. The general
outperformance of value stocks has been reaffirmed in a variety of studies. For
example, Lakonishok, Shliefer, and Vishny (1994) found value stocks
outperformed growth stocks throughout the period from April 1968 to April 1990.
Moreover, the outperformance of value stocks has also been an international
phenomenon. Fama and French (1998) found that value strategies 0utperformed
growth strategies on a global basis.
Rather than look for
low-cost deals, growth investors want investments that offer strong
upside potential when it comes to the future earnings of stocks (Berk &
DeMarzio; 2008). It could be said that a growth investor is often looking for
the “next big thing.” Growth investing, however, is not a reckless embrace
of speculative investing. Rather, it involves evaluating a stock’s current
health as well as its potential to grow. A growth investor considers the
prospects of the industry in which the stock thrives. For example, if there’s a
future for electric vehicles before investing in Tesla. Or, A.I. will become a
fixture of everyday living before investing in a technology company. There must
be evidence of a widespread and robust appetite for the company's services or
products if it’s going to grow. Investors can answer this question by looking
at a company's recent history. Simply put: A growth stock should be growing.
The company should have a consistent trend of strong earnings and revenue
signifying a capacity to deliver on growth expectations.
A
drawback to growth investing is a lack of dividends. If a company is in
growth mode, it often needs capital to sustain its expansion. This doesn’t
leave much (or any) cash left for dividend payments. Moreover, with faster
earnings growth comes higher valuations which are, for most investors, a higher
risk proposition. Around the world, investors have been favoring stocks with
strong expected growth prospects, driving the price of high valuation stocks
even higher. In the United States, most notably, in 2015 the “FANG” stocks
(Facebook, Amazon, Netflix, and Google) gained $450 billion of market cap
through the end of the year, a 61% jump, while their combined earnings rose
only 21%. Netflix’s stock surged 134% in 2015 and Amazon shot up 118%, while
Facebook rose 34% and Google (now Alphabet) increased 45%. At the end of 2015,
Netflix was trading at 409 times trailing earnings and Amazon at an even loftier
538 times.
Dodge
and Cox (2016) used large-cap U.S. stocks listed in the United States and sorted
them into three groups based on their P/B ratios. Analyzing this data, they
found that over subsequent five-year periods, the “low P/B” portfolio
outperformed the “high P/B” portfolio by an arithmetic average
of 4.48% per year. This
five-year performance differential varies over time, as plotted in Fig.2.
According to Jacobs,
Muller, and Weber (2014) a study from NYU’ Stern School of Business, “While
growth investing underperforms value investing, especially over long time
periods, it is also true that there are sub-periods, where growth investing
dominates.” The challenge, of course, is determining when these “sub-periods”
will occur. Small companies are more likely to be growth prospects, but
with growth that is at risk (Asness, et.al., 2015). For example, consider the
biotech start-up investing in R&D with little revenue against the mature
pharmaceutical company with a product line realizing earnings from past R&D;
Microfinance Vs. Banks in Nepal. Several papers, including Kok, Ribando, and Sloan
(2017) have documented that the book-to-price premium is absent from large-cap stocks.
Is this because large companies are those with lower growth prospects with less
risk?
Table 1: Results by Size
quintiles, including weights on E/P and B/P for forecasting forward returns
It depicts the difference
between high- and low-B/P portfolio returns within the five E/P groups
differentiated by size. Small companies are the smallest 30% by market cap,
large companies the highest 30%, and medium companies the rest. For a given
E/P, the return spread between high- and low -B/P portfolios is decreasing in
company size. The same pattern holds for 10-year subperiods between 1963 and 2015.
Some
growth investing style detractors including Penman and Reggiani (2018) warn
that “growth at any price” is a dangerous approach. Such a drive gave rise to
the tech bubble which vaporized millions of portfolios. “Over the past decade,
the average growth stock has returned 159% vs. just 89% for value,” according
to Money magazine’s Investor’s Guide 2018.
Growth Investing Variables: While there is no definitive list of hard metrics to
guide a growth strategy, there are a few factors an investor should consider.
Research from Merrill Lynch (2019), for example, found that
growth stocks outperform during periods of falling interest rates. It's
important to keep in mind that at the first sign of a downturn in the economy,
growth stocks are often the first to get hit. Growth investors also need to
carefully consider the management competency of a business’s executive
team. Achieving growth is among the most difficult challenges for a firm.
Therefore, a stellar leadership team is required. Investors must watch how the
team performs and the means by which it achieves growth. Growth is of little
value if it’s achieved with heavy borrowing. At the same time, investors should
evaluate the competition. A company may enjoy stellar growth, but if its
primary product is easily replicated, the long-term prospects are dim.
Momentum investors ride the wave. They believe winners keep
winning and losers keep losing. They look to buy stocks experiencing
an uptrend. Because they believe losers continue to drop, they may choose
to short-sell those securities. Jegadeesh and Titman (1993) were the first one
to uncover that the strategy (known as momentum strategy) that buys stocks with
high return over the past three to twelve months (Winners) and sells stocks
with poor returns over the same time period (Losers) earns profits of around 1%
per month over the following year. Jegadeesh and Titman (2001) observed strong
momentum returns for strategies with formation and holding period ranging from
3 to 12 months.
Dhankar (2019) think of momentum investors as technical
analysts. This means they use a strictly data-driven approach to trading
and look for patterns in stock prices to guide their purchasing decisions. Some
tend to believe that these investors trade excessively and move in and out of
stocks in a herd-like manner. This tendency to invest with the herd by momentum-based
investors by buying past winners and selling past losers is of concern, since
this behavior could potentially accelerate stock price volatility. In essence,
momentum investors act in defiance of the efficient-market hypothesis (EMH).
This hypothesis states that asset prices fully reflect all information
available to the public. It’s difficult to believe this statement and momentum
investors seek to capitalize on undervalued and overvalued equities.
Critique of Momentum Investment Strategy
Rob Arnott (2019), chairman, and founder of Research Affiliates
researched on this strategy and found that “No U.S. mutual fund with ‘momentum’
in its name has, since its inception, outperformed their benchmark net of fees
and expenses.” Interestingly, his research also showed that simulated portfolios that
put a theoretical momentum investing strategy to work actually “add remarkable
value, in most time periods and in most asset classes.” However, when used in a
real-world scenario, the results are poor because of trading costs. All
of that buying and selling stirs up a lot of brokerage and commission fees. Traders
who adhere to a momentum strategy need to be at the switch, and ready to buy
and sell at all times. Profits build over months, not years. This is in
contrast to simple buy-and-hold strategies that take a set it-and-forget it
approach.
Despite some of its shortcomings, momentum investing has its
appeal. For example, that “The MSCI World Momentum Index has averaged annual
gains of 7.3% over the past two decades, almost twice that of the
broader benchmark.” This return probably doesn’t account for trading costs
and the time required for execution.
Asness,
Moskowitz, & Pedersen (2013) illustrated, it may be possible to actively
trade a momentum strategy without the need for full-time trading and research.
Using U.S. data from the NYSE between 1991-2010, the study found that a
simplified momentum strategy outperformed the benchmark even after accounting
for transaction costs. The same research found that “the optimal momentum
trading frequency ranges from bi-yearly to monthly”—a surprisingly reasonable
pace.
Aggressive
momentum traders may also use short selling as a way to boost their
returns. This technique allows an investor to profit from a drop in an asset’s
price. For example, the short seller-believing a security will fall in price- borrows
50 shares totaling $100 and immediately sells those for $100 and then
waits for the asset to drop. When it does, they repurchase the 50 shares (so
they can be returned to the lender) at, let’s say, $25. Therefore, the short
seller gained $75. The problem with this
strategy is that there is an unlimited downside risk. In normal investing, the downside
risk is the total value of your investment. If you invest $100, the most you
can lose is $100. However, with short selling, your maximum possible loss is
limitless. In the scenario above, for example, if the stock doesn’t drop as
expected. Instead, it goes up.
Dollar-cost averaging (DCA) is the practice of making
regular investments in the market over time, and is not mutually exclusive to
the other methods. Rather, it is a means of executing whatever strategy we
chose. With DCA, investors may choose to put certain amount (Say $300) in an
investment account every month. This disciplined approach becomes particularly
powerful when they use automated features. It’s easy to commit to a plan when
the process requires almost no oversight. The benefit of the DCA strategy is
that it avoids the painful and ill-fated strategy of market timing (Barberis
& Shleifer; 2003). Even seasoned investors occasionally feel the temptation
to buy when they think prices are low only to discover, to their dismay, they
have a longer way to drop. When investments happen in regular increments, the
investor captures prices at all levels, from high to low. These periodic
investments effectively lower the average per share cost of the purchases.
Putting DCA to work means deciding on three parameters; 1) The total sum to be
invested, 2) The window of time during which the investments will be made, and
3) The frequency of purchases.
DCA
is a wise choice for most investors. It keeps them committed to saving while
reducing the level of risk and the effects of volatility. Moreover,
a DCA approach is an effective countermeasure to the cognitive bias
inherent to humans. Regular, automated investments prevent spontaneous,
illogical behavior. But for those in the position to invest a lump sum, DCA may
not be the best approach. Vanguard study (2012) finds that, “On average, an LSI (lump sum investment)
approach has outperformed a DCA approach approximately two-thirds of the time,
even when results are adjusted for the higher volatility of a stock/bond
portfolio versus cash investments.” But most investors are not in a position to
make a single, large investment. Therefore, DCA is appropriate for most. The
same study concluded, “If the investor is primarily concerned with
minimizing downside risk and potential feelings of regret (resulting from LSI
immediately before a market downturn), then DCA may be of use.”
Strategy 5: Contrarian Investment Strategy (CIS)
Long-term contrarian strategy is
based on long-term overreaction effect that was first observed by Debondt and
Thaler (1985). It suggests buying of
past low-performing stocks and selling past high-performing stocks. DeBondt and
Thaler (1985) documented a reversal phenomenon (known as overreaction effect)
with the help of US data where long-term past loser stocks outperformed the long-term
past winner stocks over a subsequent period of three to five years. They
observed the NYSE monthly return data for the period 1926–1982 by focusing on
stocks that have experienced either extreme capital gain or losses over the
period of last five years. The methodology involved the construction of two
portfolios: winner and loser. The results show that on an average the loser
portfolio outperformed the market by 19.6% and winner underperformed the market
by 5% generating a return differential of 24.6% (known as contrarian profits).
Dreman (1998) opined in
favour of contrarian investment strategy, ‘The sure thing almost nobody plays’.
Profitability of CIS over the long time horizon is observed in different stock
markets by many researchers (for example; Swallow and Fox 1998; Andrikopoulos
et al. 2011; Yao 2012, etc.) including Dhankar and Maheshwari (2014) for the
Indian stock market. The profitability of long-term overreaction-based strategy
poses the significant question on the validity of efficient-market hypothesis
(EMH).
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