Do you know what your investment style is? If you're like most investors, you probably haven't given it much thought. Yet, gaining a basic understanding of the major investment styles is one of the fastest ways to make sense out of the thousands of investments available in the market today.
The major investment styles can be broken down into three dimensions: active vs. passive management, growth vs. value investing, and small cap vs. large cap companies. Walking through each one and assessing your preferences will give you a quick idea of what investment styles fit your personality.
Active or Passive Management
In determining investment style, an investor should first consider the degree to which they believe that financial experts can create greater than normal returns.
Investors who want to have professional money managers carefully select their holdings will be interested in active management. Actively managed funds typically have a full time staff of financial researchers and portfolio managers who are constantly seeking to gain larger returns for investors. Since investors must pay for the expertise of this staff, actively managed funds typically charge higher expenses than passively managed funds.
Some investors doubt the abilities of active managers in their quest for outsized returns. This position rest primarily on empirical research shows that, over the long run, many passive funds earn better returns for their investors than do similar actively managed funds. Passively managed funds have a built-in advantage—since they do not require researchers, fund expenses are often very low.
Growth or Value Investing
The next question investors must consider is whether they prefer to invest in fast-growing firms or underpriced industry leaders. To determine which category a company belongs to, analysts look at a set of financial metrics and use judgment to determine which label fits best.
The growth style of investing looks for firms that have high earnings growth rates, high return on equity, high profit margins and low dividend yields. The idea is that if a firm has all of these characteristics, it is often an innovator in its field and making lots of money. It is thus growing very quickly, and reinvesting most or all of its earnings to fuel continued growth in the future.
The value style of investing is focused on buying a strong firm at a good price. Thus, analysts look for a low price to earnings ratio, low price to sales ratio, and generally a higher dividend yield. The main ratios for the value style show how this style is very concerned about the price at which investors buy in.
Small Cap or Large Cap Companies
The final question for investors relates to their preference for investing in either small or large companies. The measurement of a company's size is called "market capitalization" or "cap" for short. Market capitalization is the number of shares of stock a company has outstanding, multiplied by the share price.
Some investors feel that small cap companies should be able to deliver better returns because they have greater opportunities for growth and are more agile. However, the potential for greater returns in small caps comes with greater risk. Among other things, smaller firms have fewer resources and often have less diversified business lines. Share prices can vary much more widely, causing large gains or large losses. Thus, investors must be comfortable with taking on this additional level of risk if they want to tap into a potential for greater returns.
More risk averse investors may find greater comfort in more dependable large cap stocks. Amongst the names of large caps, you will find many common names, such as GE, Microsoft, and Exxon Mobil. These firms have been around for a while, and have become the 500 pound gorillas in their industries. These companies may be unable to grow as quickly, since they are already so large. However, they also aren't likely to go out of business without warning. From large caps, investors can expect slightly lower returns than with small caps, but less risk, as well.
The Bottom Line
Investors should think carefully about where they stand on each of these three dimensions of investment style. Clearly defining the investment style that fits you will help you select investments that you will feel comfortable holding for the long term.