Developing a disciplined, long-term strategy. |
| Day 4/10: Investing vs Trading |
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In the world of investing, the old saying "We are our own worst enemy" holds true. Fear, greed, overconfidence, and following the crowd can drive us to make irrational decisions. Acknowledging these tendencies and adopting a disciplined, long term strategy can help counteract the detrimental effects of emotional biases on investment choices.
One great fact about the stock market is that, regardless of price fluctuations, new opportunities are always arising. With a little bit of effort, you can be rewarded by these opportunities that help you build wealth over time. |
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When it comes to investing and trading, you should know there is a difference. Investing involves purchasing securities with the goal of generating long term returns from income, capital gains, or both. Emphasis is on the long term. You will likely focus on a stock's intrinsic value and company operations, not on daily price movements.
Trading, on the other hand, involves buying and selling stocks because of price fluctuations. Traders focus on short-term gains, whether that be a few hours, days, or even months. While trading is often compared to gambling, it can still provide liquidity to the market though with higher risk relative to investing. |
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| Active vs. Passive Investing |
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When investing, two common approaches to increasing capital are active and passive strategies.
Active investing involves selecting individual investments with the purpose of outperforming the market. By buying low and selling high, you can achieve capital gains and you can then reinvest the same profit for further growth.
Active investing requires more time for in-depth research to identify investment opportunities. Alternatively, you can tap resources that do the analysis for you with the end goal of beating the market.
Passive investing, however, involves choosing investments and simply holding them for the long term, waiting for them to grow in value and produce dividends or income. Unlike active investing, this buy-and-hold strategy typically aims to match the market's performance with low-cost index funds or undervalued stocks. It requires less effort than active management. |
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| Small-cap vs. Large-cap; Growth vs. value |
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Over time and with enough experience, many investors have a preferred style, be it with varying degrees of risk and potential return. Market capitalization is a common focus, with preferences for large-cap, mid-cap, or small-cap stocks.
Valuation is another consideration, with either value or growth stocks in the mix.
Growth itself can be defined in several different ways. For some investors, a growth stock is one that has a relatively high price - book ratio (book value is a financial measure that represents the value of a company's assets minus its liabilities). For others, growth refers to a stock that has a higher-than-average expected rate of earnings growth.
Here are some of the most common investing styles:
Large-cap value. You’d want to consider investing in large-cap value stocks if you want reputable companies (blue chips) with a history of steady earnings. These companies have low price-book ratios and high market capitalizations, and they often provide generous dividend yields or payout ratios. However, they aren't without risk and may lack innovation, which could reduce demand for their products.
Small-cap value stocks have small market capitalizations and low price-book ratios. They usually have a steady income stream and operate in a well-defined market niche. They may also pay generous dividends, but the risk is that the market for their products may quickly change, and they may lack the resources to withstand major market upheavals.
Large-cap growth stocks have high price-book ratios and low dividend yields. They are expected to grow rapidly, and they tend to be innovative. However, their projects may fail and cause their earnings to be volatile.
Small-cap growth stocks usually have one big idea that is very promising, but they have never turned a profit and they rarely pay dividends. Investors perceive them as having value due to the potential for large returns. |
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| Dividend vs. Capital Gains |
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Dividend and capital gains investing strategies represent two of the most common but different approaches to generating returns from investments. Let's explore the pros and cons of each strategy so you can decide which one is right for you.
Dividend Investing: Dividend investing involves selecting stocks or funds that provide regular income through dividend payments. Here are are some pros and cons of this approach:
Pros: |
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Capital Gains Investing: Capital gains investing involves buying assets with the intention of selling them at a higher price to realize a profit. Here are the pros and cons of this strategy:
Pros: |
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Flexibility: You have the flexibility to choose from a wide range of assets, such as stocks, real estate, or bonds, providing diversification options.
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QUIZ
1. Which of the following is an example of passive investing?
A. Analyzing market trends
B. Monitoring individual stocks
C. Investing in an index fund
D. Selling stocks after a certain percentage gain
2. Which of the following is an example of active investing?
A. Investing in a mutual fund
B. Investing in an index fund
C. Analyzing market trends
D. Selecting individual stocks
Homework: Building wealth is a cumulative process. It’s often helpful to begin the process by taking a personal financial inventory. Create a financial balance sheet to get a sense of your net worth and how you currently spend your free capital. Evaluate your own income and expenses. Then, calculate the amount of capital you have available for investment purposes whether on a monthly, quarterly or annual basis.
Tomorrow’s topic: an introduction to financial statements. |
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