Topic: Value Stocks

3 common approaches to investment decision making: Which one is best for you?

approaches to investment decision making

Many investors like to describe different approaches to investment decision making by sticking a one-word label on them.

This can make conversations flow more smoothly, but it does little to raise anybody’s investment knowledge. In fact, it can lead to false impressions.

Three of the most common one- or two-word labels in stock investing are growth and value. You’ll find each of those approaches to investment decision making in a successful investor’s portfolio. But going to extremes with any single one hurts your profits.


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Common approaches to investment decision making: Growth investing

Of course, you need a growth element in your portfolio. Profits from successful growth investments can offset the drain of disappointing stocks, which are inevitable in any portfolio. But too much focus on growth can lead you to buy stocks that are in the broker/media limelight. Many of these stocks need huge profit gains to justify their current stock prices, let alone move higher. If their growth stalls, it can bring on brutal stock-price downturns.

Among the considerations that go into a successful growth investing strategy, many investors overlook a number of important factors that can considerably lower their risk. Here are some of them:

● Don’t overindulge in aggressive investments.
● Keep stock market trends in perspective.
● Be skeptical of companies that mainly grow through acquisitions.
● The best growth stocks should have the ability to profit from secular trends.
● Keep an eye on a growth stock’s debt.
● Look for growth stocks that have ownership of strong brand names and an impeccable reputation.
● Balance your cyclical risk.

Common approaches to investment decision making: Value investing

Too much focus on value can lead you to ignore valuable information. For instance, a below-average P/E ratio (the ratio of a stock’s price to its per-share earnings) can signal danger, rather than a bargain. It can alert you to look for reasons investors might have for being skeptical.

A low p/e may indicate that a company is being run for the maximum current profit, without regard to the long-term needs of the business. This may spur its managers to disregard signs of coming business weakness. They may fail to make needed capital investments. Or they may ignore shrinking demand, rising competition due to advancing technology, or risks of a cyclical downturn.

Academic studies suggest that on average, value investing produces better results than growth investing. But these studies mostly look back on what would have happened in a particular historical period, if you followed a particular set of rules. Most distinguish between growth and value investing by looking at average p/e’s (per-share price-to-per-share earnings ratios). They assume high p/e’s are a marker for growth stocks and low p/e’s for value stocks. As any serious value or growth investor can tell you, it’s more complicated than that.

If you balance and diversify your portfolio as we recommend, it should include both growth and value selections. In both areas, you should avoid extremes.

Common approaches to investment decision making: Momentum investing

You might say momentum investing is the most modern of the three approaches, since its fans often try to computerize their investment decisions. They aim to profit with software that can spot patterns in the vast amounts of stock-market information available today.

The momentum approach can pay off for short periods. But its fatal weakness is that momentum investing is inherently a short-term strategy, so it can lead you into short-term trading. The shorter the term, the more exposed you are to random factors in the stock market.

Successful investors are more likely to look on momentum-based buy and sell signals as a way to see if they are in tune with, or at odds with, the market’s short-term trend. Either way, these signals are a reminder to look more deeply and widely for profit-making opportunities.

All in all, you’ll find signs of growth and value strategies in a successful investor’s portfolio. To make the two factors work profitably together, those successful investors also add a third: an emphasis on investment quality.

Approaches to investment decision making : Keep long-term conservative investing goals in mind

The goal of an investor, particularly if you follow the Successful Investor approach, is to make an attractive return on your investments over a period of years or decades. Failure means making bad investments that leave you with meagre profits or losses.

Unsuccessful investors can still make some profits. They just don’t make enough to offset the inevitable losses and leave themselves with an attractive return. If you focus on the idea that you never go broke taking a profit, you may be tempted to sell your best investments whenever it seems the investment outlook is clouding over.

On occasion, you may succeed in selling just prior to a major downturn, and buying back at much lower prices. More often, prices will soon hit bottom and move up to new highs. If you buy back, you’ll pay higher prices. If you had followed this investment belief with Canadian bank stocks, for example, you could have missed out on some big gains over the years.

In hindsight, market downturns are easy to spot. Spotting them ahead of time is much harder, and impossible to do consistently. After all, if you could consistently spot market downturns ahead of time, you could acquire a large proportion of all the money in the world, and nobody ever does that.

The problem is that you’ll foresee a lot of market downturns that never occur. All too often, the market-downturn clouds disperse soon after skittish investors have sold. Good reasons to sell do crop up from time to time, of course, even if you follow a long-term conservative investing approach. But “You’ll never go broke taking a profit” is not one of them.

There are plenty of approaches to investment decision making. Is there an approach you’ve tried that isn’t worth doing again? Do you have one that works best for you?

This article was originally published in 2017 and is regularly updated.

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