Virtually all investors subscribe to a form of investment philosophy or style. And the same way fashion style dictates the clothing you wear, investing style determines the portfolio you build. Let's look at some basic elements of investing style and examine some different styles, along with some systematic anomalies that can be important for all types of investors to be aware of.
- All investors should develop an investing style.
- There is virtually an unlimited number of investment styles; some of the most common types include growth investing and value investing.
- Determining risk tolerance plays a key part in choosing an investing style.
- Investing style may also be dictated by an investor’s trading and rebalancing preferences.
Developing an Investing Style
Style investing for a portfolio typically first begins with an investor's risk tolerance. Generally, younger investors will often have the latitude to take on higher amounts of risk while older investors steer toward lower-risk investing. Regardless, all types of investors will want to establish some ratio proportions. This can sometimes be easily done with funds that holistically manage for a balanced allocation like 60/40, 20/80 and so on, or a fund with a strategic allocation that comprehensively meets a specific goal. Many do it yourself (DIY) investors, however, choose to define these ratios on their own with more flexibility for building their own comprehensive portfolio over time.
With an established risk tolerance, investors can delve deeper into style quadrants for their own diversified portfolio. At this more granular level, "style" often refers to groups within a broad category (such as equities or fixed income) that display unique characteristics.
Risk-based style investing gives investors the flexibility to choose from an array of opportunities within their ratios. Style is integral both at a comprehensive asset allocation level and a granular level; it's also a key element of modern portfolio management. Studies conducted over the years show that asset allocation can be a significantly more important attribute of portfolio performance over time than, say, individual investment selection or market timing.
The study, "Determinants of Portfolio Performance" (Financial Analysts' Journal, 1986), showed that 93.6% of portfolio performance was due to asset allocation.
Types of Investing Styles
Value investing is a style that is often paired with the moderately conservative investor who wants to obtain higher returns from the stock market over time with the least amount of risk. It picks equities that are characterized by low fundamental ratios and high dividend yields. Benjamin Graham, the godfather of value investing, suggested that value investors stick to stocks with price-to-earnings ratios of 20 or lower. Value investing also often overlaps with income style investing, which seeks high levels of income across multiple asset classes. As more established, stable businesses with steady revenue, income and cash flow, value companies usually offer the benefit of their steady returns in the shape of dividends.
Value stocks also often tend to outperform in a volatile or deflating equity market environment. This is because they have more rational valuations with a strategy that has navigated through the test of time. Many active DIY investors will often shift more heavily to value stocks in bearish markets to maintain their wealth through rough market downturns.
Investing for growth is another style, often suited to aggressive investors, or those who have long-term horizons, which allows them to ride out market ups and downs in general and the volatile behavior of growth stocks in particular.
Growth stocks often perform the best when an economy is booming, leading to an environment that is conducive to the introduction of new products, innovation, and consumer demand. Strong growth in the gross domestic product (GDP) numbers often parallels the performance of growth stocks in the market.
The Style Box Approach
Morningstar Inc., the financial research firm, created the style box as a basis for helping retail investors in DIY investing.
Constructing a style box for a portfolio is relatively straightforward. The first thing to do is to determine an asset allocation balance. Then, within these buckets, allocate investments using the "style box" approach.
The evolutions and use of the style box led to some distinctly characterized styles. In equities, these styles include large-, mid- and small-cap stocks, overlaid with value, blend, and growth. In fixed income vehicles, the Morningstar style box quadrants divide up by maturities overlaid with high, medium and low credit quality. These quadrant variables help to form the basis for style investing but there can also be more or sub-segments thereof.
If your portfolio is heavily weighted toward equity you can choose between single stock investments, funds or a combination of both. In equities, you will want to watch a stock’s beta (a measure of systemic risk) and the overall portfolio's Sharpe ratio, (a method for calculating the risk-adjusted return).
Both of these measures are statistical metrics that help an investor to evaluate and compare risk.
Fixed income investing often provides the advantage of combining lower risk with steady income. In this asset class, quality investing choices will typically show many of the same trends as in the equity market as companies are evaluated based on their financial statements and debt levels. However, investing across maturities can require a little more skill and monitoring. In the fixed income market, a bond's duration is an important risk metric as it provides the amount an investment’s value will fall per percentage change in interest rate levels. Thus, in a rising rate environment, it can be better to stick with shorter maturities.
For investors managing their own portfolios, the risk environment can often be an important trend to follow. Equities tend to deflate in rising rate environments and gain in low rate environments. Rising rates and inverted yield curves with short term rates higher than longer-term rates are also usually signs of a slowing economy or recession.
Trading and Rebalancing
Investing style may also be dictated by an investor’s trading and rebalancing preferences. High-frequency traders may have the advantage of identifying and capitalizing on short-term market trends. Low-frequency traders, however, may choose to use scheduled rebalancing time periods in their portfolio investing. Regardless, choosing a rebalancing schedule can also be an important factor for style investing.
Staying aware of the market environment can often be helpful in a rebalancing schedule. This will typically require an investor to follow how interest rates are being managed. For example, after the financial crisis, from 2008 to 2015, the Federal Reserve reduced the federal funds rate to zero in 2008 and held it at zero for seven years. Since 2015, the Federal Reserve has increased the fed funds rate from zero to as high as 2.25%, then began pulling back as economic growth seemed to stall. As of June 20, 2020, the target range for the federal funds rate is 0%–.25%.
Assessing the percentage allocation across all styles in a portfolio on a regular basis is also important. For example, from 2008 to 2015, the Nasdaq soared, gaining 109%. While these gains were beneficial to technology investors, they also led to technology overweights that were important to manage through rebalancing. Rebalancing to sell off some winners and invest in other areas is beneficial for following target weights.
Finally, style classes are not static. A large-cap value or small-cap growth stock does not stay that way forever. Thus, rebalancing can also help to maintain awareness of market changes to particular style allocations of a total portfolio. Investing circumstances and portfolio weights constantly change, so it is important to also establish a regular rebalancing schedule for comprehensive portfolio assessment.
The Bottom Line
Style is a fundamental component of portfolio management. Comprehensively it is usually dictated by an investor’s risk tolerance. From there, investors also have a broad array of style options to choose from on a more granular level.