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My FI Journey » Investing » A subjective comparison of investment strategies

A subjective comparison of investment strategies

1217630_chess_2I’ve been involved in investing in some form or fashion for well over a decade.  Over that time I’ve tried a number of different strategies including index funds, dividend growth (current favorite), and speculating.  Each different type of investment requires a different level of knowledge to achieve entry level proficiency and carried with it a different level of risk.  Hopefully, the list below will help you better understand which style of investing you may be interested in based on your available time and risk tolerance.

Effort and Risk

Effort - Represents the minimum time and mental energy one would need to spend in order to produce passable results, meaning not losing large swaths of your money.  Note the use of the term minimum, one can always expend more effort and get better results.  My rankings of effort are as follows:

  1. Catatonic
  2. Some
  3. Moderate
  4. Hard
  5. Full time career

 

Risk - Represents how dangerous a given investment is.  In other words, how likely you are to lose a boatload of money  because of your own mistakes or a market downturn.  I’m aware that you could write a scenario where any scenario turns out to be incredibly risky, but for the purpose of this thought exercise I’d like to avoid thinking in terms of extremes.  My rankings of risk are as follows:

  1. Low
  2. A bit more than low
  3. Moderate
  4. High
  5. Holy crap!

Investment Strategy Rankings

Below is my rationale for why I ranked each investment strategy as I did.

Index Funds / ETFs

Index funds are essentially the most brain dead investment out there, hence they require the least amount of effort to initiate and maintain.  Just because i describe them as brain dead, doesn’t mean that they’re a bad choice.  They’re actually the best choice for most people because they are super easy to use and produce respectable returns over the long-term.  Just grab a low cost stock market index fund, a bond fund, and check back once or twice a year to re-balance.

There are downsides to all that ease of use.  The first is that you have to pay regular maintenance fees to the mutual fund company.  The second downside is that the index isn’t based on any concept of valuation, so within that basket of stocks that the fund is holding are some winners and some losers.  You’re stuck with the junk along with all the rest.

I include exchange traded funds (ETFs) in this category as well since as far as the average investor is concerned, they’re nothing but sexier versions of mutual funds.

 

Dividend Growth Investing

Dividend growth investing, a type of value investing, is currently my favorite investing method.  Overall, I feel that dividend growth investing can be pretty easy for a dedicated newcomer to approach.  First, there is only a very small universe of stocks to chose from and this collection of stocks is made considerably smaller if the beginning investor applies filters removing stocks with a small market cap or low entry yield.

A certain level of research is required to be an effective dividend growth investor.  You should be familiar with the champions, contenders, and challengers list.  You should be at least moderately comfortable reading stock analyses (even if you don’t do them yourself).  And you should understand a handful of investment terms (PE ratio, yield, payout ratio, etc.).

I consider dividend growth investing to be one of the least risky investment strategies out there for two reasons.  First, you select companies based on strong fundamentals – in other words because they are objectively good businesses.  Second, part of your total return is provided to you in the form of cash dividends.  Regardless of what happens to the stock price, you still get to keep the dividend.

 

Value Investing

Value investing is similar to dividend growth investing in its focus on the fundamentals, but is open to the whole universe of stocks regardless of whether they pay dividends. And just like dividend growth investing, regular research and a basic set of knowledge is required to be able to succeed.  I won’t say much about value investing since all of the same principles discussed above apply here as well.

 

Cash-Secured Puts

I’m going to begin by assuming that you’re writing puts against stocks that you have already evaluated using the principles of value (or dividend growth) investing.  If not, jump immediately to the section on speculation.  I wouldn’t consider writing cash-secured puts more risky than value investing, simply because if you’ve done your homework the downside risk (being assigned the stock) wouldn’t be any worse than if you had bought the stock outright.

Selling cash-secured puts is a bit more involved than just buying stocks for the simple reason that you must not only understand the underlying stock, but must also understand options markets.

 

Naked Puts

Again, I’m going to assume that you’re only writing puts against stocks that you have properly evaluated.  if not, head on down to the section on speculation.  Essentially, selling naked puts requires no more effort than cash-secured puts.  The difference comes in risk.  With naked puts, margin comes into play, and the investment risk increases as you push the limits of your margin allowance.  It is entirely possible that you can lose a lot of money if you push the maximum of your margin allowance and the market takes a nosedive.  Yes, even if you focused solely on the fundamentals and bought great companies, you can still lose money when margin comes into play.

 

Speculation

By this point you’ve thrown all principles of value investing out the window.  Is defenestration of an idea even possible?  I consider speculation any kind of profit chasing not based on solid investment fundamentals.  This includes chasing IPOs (initial public offerings), hot stock tips, water cooler advice, gut feelings, etc.  Speculative strategies appear great in a bull market because almost everyone makes money hand over fist.  But during a declining or flat market is when the risks of speculation become apparent.  And make no mistake, once you’ve given up basing your decisions on actual data, only bad things can happen.

 

Day Trading

The essence of day trading is buying and selling large amounts of the stock on the same day using margin to further amplify your gains.  In order to be successful at day trading you have to be willing to expend considerable effort understanding the market, understanding how the market moves (technical indicators), and waiting for opportunities.  This is essentially a full time job.  And it’s a job that carries a profound amount of risk.  If you don’t know what you’re doing, you can and will lose a lot of money very fast.

 

Readers:  What is your favorite investment strategy?  Your least favorite?  How would you rank them in terms of effort and risk?

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19 Responses to "A subjective comparison of investment strategies"

  1. Great article. We, of course, would be in the index fund/EFT group right now with our limited knowledge of investing. But my goal is to get heavily involved in dividend growth investing. We’re highly interested in this as a passive income form.

    1. MFIJ says:

      If Index funds/ETFs represent the current limit of you’re knowledge, you’re better off than a lot of people by admitting that and working with it. I have some friends who bought into the Facebook IPO despite having no real knowledge of investing or IPOs… The results were predictable.

      As you learn more about dividend growth investing, you’ll start to become more comfortable with it. And kudos to you for holding off until you actually learn a bit rather than jumping right in.

  2. I definitely am more the index investing style. I’d like to move up the ladder a little bit and take more control. However, not unlike how I make it rain by washing my car, I’m pretty sure I’ll crash any stock I buy. But, still, I’ve been doing some research and will begin dipping my toe into this area.

    1. MFIJ says:

      About half the time that I buy a stock it goes down in price for the short term. But out of my nearly 30 investments, only two (TEF and NRGY) have proved to be complete dogs that I decided to dump after a year. But I went into those knowing that they were likely to be risky.

  3. Nice overview. I’d like to be somewhere in the moderate range, but I’m currently in the Catatonic stage just because I don’t have a ton of money invested so I’ve been sticking to index funds and ETFs. I don’t want something that I need to pay attention to daily, but I would like something that requires a bit more time.

  4. I think with my money till I reach financial independence I want to have the “low” risk investments.

    If my future would be secured, I would go into different type of investment – buying the companies and turning them around. Daily trading and the rest is exciting but it is gamble as well.

  5. Will says:

    I think the first two are the best options. Index investing is a great idea for someone who doesn’t have the time or energy to research individual stocks. I actually plan on buying the VOO (Vanguard S&P 500) index fund at some point to help anchor my portfolio. Index investing is a good idea for a large majority of the population.

    However, like you, I prefer dividend growth investing for the same reasons you point out. I love getting regular income in the form of dividends in addition to the appreciation of the stock price. I hope at some point in the future to live off of my dividend income, and will at the very least use it to pay for my kids’ college. I think it’s a great strategy that is almost guaranteed to be successful in the long run.

  6. While I love your overall assessment, I think the index fund/ETF chart “risk” level isn’t completely correct. Some of the ETFs out there offer HUGE risks to investors (individual country indexes, the ProShares Ultras, etc.). While the basics (Diamond, Spyder, etc.) are exactly as you say they are, investors can get into a heap of trouble with some of these investments.

    I rarely “L.O.L.”, but I have to tell you that I did grunt out load when I read your “Holy Crap!” line. That was awesome.

    1. MFIJ says:

      You raise a good point. I should have been more clear in stating that I meant index funds based around major indexes, such as S&P500, Wiltshire 5000, Russel 5000. Some index funds can be outlandishly volatile like emerging market funds, or leveraged 2X or 3X funds.

  7. Terry says:

    I like to play it pretty safe in the market. My strategy may be below catatonic. I only buy mutual funds.

    I think that I get the best long term gain in rental houses.

    1. MFIJ says:

      Making money with rentals is a skill that I would love to learn. It’s hard, if not impossible, to master a number of different asset classes. So if you’re jamming in direct real estate investing then mutual funds are good enough.

  8. Like Joe, I think I literally bust a gut laughing at your “Holy Crap” in regards to Day Traders. I am definitely in the moderate camp with leanings towards hard. I have been wanting to do some cash secured puts, with the intent of building up to naked puts, but just have not carved out the time needed to do it effectively.

    1. MFIJ says:

      Just think about puts the same way you would think about stocks. If you wouldn’t buy the stock, don’t sell the put. After that, make sure that the put offers enough of a premium to make it worth selling. I shoot for at least 10% annualized. And try to make sure that the strike price is towards the 52 week low to lessen the risk of assignment.

  9. Is there a way to evaluate success for each of these investment strategies? I suppose we each think that we wouldn’t be well-represented by an average of all people following that strategy.

    We’re invested in index funds, though my husband is learning about dividend growth investing.

    1. MFIJ says:

      That’s an excellent question, Emily. You get the gold star today.

      Unfortunately, I don’t have an excellent answer. Gauging the performance of an index fund is easy, you just look up the performance of the index (the composition of which is predefined). The other methods get harder to judge because they are individual and each investor adds capital at different times and chooses investments based on different criteria.

      Dividend Growth Investor just published an article looking at the dividend Champions vs the S&P500. Although that is comparing an index to an index rather than a strategy.

      If you were really enterprising you could set up a series of investment criteria and back-test it.

      Options if used correctly generally increase returns. The reason is simple. Assume that you have a margin account and sell an option. If that option is never assigned, you basically got a few hundred dollars in options premiums deposited into your account for doing nothing.

      The best advice I have for you is to find other investors who share their returns and portfolios and start following them. The transparent ones will report everything. The not-so-transparent ones will only report the wins and maybe a handful of losses. I’ll be posting my total returns for the last 3 years sometime next month. I’ve got the post written, I just need to schedule it.

  10. Great article =) I’m not a super big risk taker and I get it from my parents! My riskiest investments are automated….that way I don’t get too involved and backtrack!

  11. Pauline says:

    Like Joe said indexes can be a bit risky. I used to have an Asia Pacific index that went 2 digits up and 2 digits down year to date. But they are easy and hands off.

    1. MFIJ says:

      I really should have been more specific and focused on the major US stock indexes.

  12. Martin says:

    I loved your classification on risk on day trading “Holly Crap”. You made my day.
    I like definitely the dividend growth strategy, cash secured, and naked puts on stocks I want to own in case I get assigned. I tried other strategies such as swing trading (never day trading), but the dividend strategy worked the best for me so far, so sticking to it.

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