Still trying to figure out your investment strategy for the equity market? Or maybe you started investing and made some losses. Before you think of investing as gambling, read about the strategies used by investors below.
When I refer to investors here I mean those who have a strategy when trading, not the people who are just 'winging' it, and buying what the neighbour mentioned yesterday.
So there are 2 types of equity investors today:
1. Classical Investors
2. New Age Investors
Classical Investors: Sharmaji ke bachhe
The Classical investors are those who do fundamental research before buying a stock. They look for underlying value at a good price with a large margin of safety. They buy a stock with the hope that the market sooner or later realises the value of that stock and the share price will rise.
These are further divided into two types: value investors and growth investors. There are a couple of minor differences between the two.
Value investors are the world's most stubborn investors. They have a rule that says buy low & hold till there is a change in fundamentals. For some investors, that could mean that they keep holding for decades!
They only invest in industries of which they have a clear understanding, and are established businesses which are currently undervalued. The world's most famous value investor is Warren Buffet. Even someone as successful as him did not take a large bet on technology stocks till 2016, when Berkshire Hathway finally invested in Apple.
Growth investors are similar to value investors except that they have a different entry criteria. They look to buy young businesses that have a growth rate that is faster than the industry average. They sell that share once it has grown significantly and the growth has stagnated.
These are 'adarsh' investors. The 'Sharmaji ke bachhe'. The ones who understand the metrics, do fundamental research to pick stocks and have a superior understanding of industry nuances. Most people who get into investing aim to become one of these investors.
But today, we are seeing a new investment philosophy that is 'gaining momentum'. Literally.
New age investors: The black sheep of the family
Investors today are increasingly looking at using algorithms instead of fundamental research to pick stocks. If this report is to be believed, 30-40% of the total market volume is traded using algorithms & computers, not humans!
There are already large mutual fund houses (UTI NSE200 Momentum 30, DSP Quant fund) which are adopting quantitative strategies.
This style of investing is broadly called algorithm based investing or 'algoinvesting', and one of the most popular strategies of algoinvesting is Momentum strategy.
Momentum investors chase growth, just like growth investors, but with a slight caveat. They don't choose based on the fundamentals of the stock, or the valuation. They let the market be their yardstick.
A momentum investor will choose a stock purely based on price trend. They don't care if the stock is the most expensive in it's industry or if it has high P/E or P/B ratios. They only care about price movement. If the trend is signalling up, then you buy, if the trend starts signalling down, then you exit.
We have seen hugely successful momentum or quant based funds coming up today, that manage some serious money. You can read about some of them here.
How to identify your type?
Now that we've seen both momentum and classical investing, let's get into the differences to find out which is more suitable for you:
Exit Criteria
The first difference is that a momentum investor can drop a stock as fast as they bought it, sometimes as soon as a couple of weeks. This would either be when the algorithm realises the pick was wrong and tells you to exit, or when you have made a profit and your rules tell you that it won't give any more.
On the other hand, a classical investor won't sell when the stock price falls, in fact, they might buy more. The exit criteria of a classical investor is subjective. It depends on when the fundamentals of the business are no longer favourable.
Stock Churn
A classical investor usually has somewhere between 3 to 20 stocks in their portfolio, most of which they would not sell for months or even years. The stock prices may not go up but classical investors are patient and will keep holding, because they believe in the fundamentals.
A Momentum investor on the other hand, would sell approximately 10-20% of their portfolio every month. They believe in performance. The rule is to keep the stocks that are performing well, and churn (sell) the ones that don't. During this time, they might even sell a share of business which later starts to perform well.
This brings us to the most important difference.
Good Business vs Good Stock
This is the biggest difference between the 2 investor types. A classical investor can only invest in good businesses. Whether that leads to profit or not doesn't matter, they will only buy 'good' businesses.
A momentum investor on the other hand, could invest in 'ugly' businesses. The business may not have sound fundamentals but if the market price is going up, a momentum investor will say "Hey, why not?".
Now that you understand the differences, you might relate to one of the types. Now comes the hard part, picking one of the two investing philosophies.
How to pick an investment philosophy?
What makes an investor successful, is having the conviction to stick to your strategy, whether that strategy was based on rules or based on fundamental research.
This is because at the end of the day, all strategies have the potential to work. The key criteria is to let your investment compound.
Now you can choose one based on your expertise. If you are a business expert because of working in a certain industry, you could do fundamental based investing in that industry.
For example, if you are a doctor, you may understand what exactly happens when a certain drug trial is passed & whether it would mean a higher chance of success for the drug on the market. Based on this knowledge, you could choose to invest in that stock which is manufacturing the drug.
Not everyone has the expertise or the inclination to do this fundamental research. The other choice is to make a certain set of rules, and invest based on those, maybe using a momentum based strategy. The algorithm that you create can be tested in previous market conditions to check its performance.
Managing Risk in your strategy
The risk of underperformance is very real over the short term. In the longer term everything balances out. There is some risk in all forms of investing, but successful investing is in managing risk, not avoiding it!
One way of managing risk is to diversify across strategies and across funds. Most investors today do mutual fund investment along with some fundamental investing & some amount in momentum or other strategies. That way even if one strategy underperforms, the others could balance it out.
The most important thing is to stick to your strategy for the long term.
And if you feel that you cannot create your own strategy, you can always look for professionals who do it for a small fee (including us), for both fundamental or algorithm based investing.
Do reach out if you want to talk with us. All the best for your (algo) investing journey!
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