The Amsterdam stock exchange (AEX) was formed back in the early 1600s and is considered by many to be the oldest stock exchange globally. As European trade grew in this period so did the demand for banking. The Dutch East India Company was formed in tandem to compete for exports, and would offer shares on the AEX to financiers of the expensive expeditions. Needless to say there have been significant developments to the investment landscape since then, notably financial globalisation, tools used to facilitate trades and strategic investment methods.
The ability to implement robust investment strategies has evolved in line with modern technology; specifically the use of algorithms. Algorithmic trading can provide greater accuracy and speed with reduced costs for the investor. This provides a more systematic approach to active, and even passive, investing compared to traditional, manual methods.
But, what is an investment strategy? In simple terms, it is a set of rules and procedures to be followed by an investor to make portfolio allocation decisions – the design and implementation of trading algorithms automates this process.
Technical and Fundamental Analysis
Technical analysis involves forecasting price changes based upon historical volume and pricing data, helping investor’s to make informed decisions.
Fundamental analysis, on the other hand, focuses on a wide range of data (beyond historical price and volume) related to a company to assess its value. This data encompasses both internal and external factors that may influence future price movements. For example, financial ratios, industry trends and company statements can help investors form a view on valuations aligned with macro and microeconomic factors, ultimately to support portfolio allocation decisions.
Considering both technical and fundamental methodologies can be an efficient way to invest.
Passive and Active Approaches
Whether an investor decides to follow a passive or an active approach depends on their investing preferences.
Passive investors tend to trade over a longer time horizon and avoid volatile pricing trends by executing a ‘buy and hold’ strategy; ultimately, the goal is to realise long-term price appreciation with the help of sound fundamental analysis.
Contrarily, active investors will generally continuously monitor their activity, using technical analysis, to trade frequently and take advantage of short-term price fluctuations to generate profits. These investors aim to outperform the benchmark index, whilst passive investors look to track the benchmark.
Passive investing tends to involve less risk and volatility over time than active investing, however active investors have the potential to recognise significant returns when successful. Passive investing also brings strategic simplicity with low transaction costs, whereas active investing involves higher costs, but allows flexibility in reacting to news events and trends to rebalance portfolios.
Strategies
Let’s get into the strategies…
Allocating resources to dividend-paying stocks can be a profitable way to invest.
Dividends are payments made to shareholders derived from a company’s net income and are often paid on a quarterly basis. The proportion of net income paid out by a firm as dividends is called the payout ratio. Contrarily, the retention ratio is the percentage of net income retained after dividends are paid, which is used to reinvest for growth purposes or as working capital.
Another important related concept is the dividend yield, which is the ratio between the dividend paid per share and the current share price.
Dividend Strategy
Investing in high dividend yield stocks can provide significant returns in the short-term, however this might be unsustainable in the medium to long-term. If a firm has a high payout ratio they are reinvesting less income for growth, which could be harmful for the future. Similarly, if a firm has recently experienced a significant price drop, their dividend yield may appear artificially inflated. If the reason the share price fell was due to poor company performance, or a systematic problem in the industry, or economy, the dividend level may be unsustainable. It is therefore important to look for consistency and even growth over time in the dividend yield.
Investing in firms with higher retention ratios is a high growth dividend strategy. When a firm builds up a large cash warchest they can either invest to promote growth, they can repurchase shares in a ‘share buy-back’ to drive up the share price, or they can pay out higher dividends – and it is often a bet that the firm will pursue the latter of these three options that dividend growth investors seek.
Momentum Strategy
A momentum-based strategy is a well known investment strategy that uses technical analysis to calculate the percentage change of a stock price over a period of time. Positive momentum corresponds to increasing prices, whilst negative momentum represents decreasing prices. The aim of the strategy is to take advantage of price volatility to buy low and sell high; the strategy is implemented to identify positive uptrends to buy as momentum is increasing, and sell as stocks are losing positive momentum to make a profit. A momentum strategy will generate a buy signal using algorithmic analysis when a stock is displaying an upward trend in its price, or a sell signal conversely.
Value Strategy
Benjamin Graham is a famous economist that contributed significantly to the method of Value investing. This method seeks to determine whether a stock is undervalued or overvalued compared to the rest of the market, and therefore if it is priced above or below its intrinsic value. In order to do so, for example, an investor may execute fundamental analysis considering financial statements and market news. Investing in good value stocks gives an opportunity to pursue long term growth with relatively lower risk. A Value strategy will generate buy signals when a stock is undervalued, if the indicator is strong enough, and conversely a sell signal if a stock is overvalued compared to the rest of the market.
Strength Strategy
J. Welles Wilder developed the Relative Strength Index (RSI) strategy, which includes a momentum oscillator measuring the speed and change of price movements – an investor can obtain the strength of a stock by interpreting this index. According to the strength indicator, when prices rise quickly in the short-term the asset may be overbought, and a price reversal may be expected, conversely a sharp decline in prices may indicate the asset is oversold and the opposite reversal may ensue. This is useful, for instance, to generate profits by determining when to exit a position if a drop or rise is anticipated. An RSI strategy will generate automated buy and sell signals when algorithmic analysis determines a stock is overbought or sold.
Volume Strategy
On-Balance Volume (OBV), a strategy developed by Joseph Granville in the 1960s, involves technical analysis to measure buying and selling pressures in relation to security volumes traded. Transaction volume is recorded on days in which the previous closing price is higher than the current close (down-days), and when the current closing price is higher than the previous (up-days) – no action is taken when closing prices are equal. Up-days are added to the cumulative score and down-days are subtracted. Following Volume signals can potentially generate short-term profits when buying stocks with significant up-day pressures, since a price rise could potentially follow. Likewise, by selling securities with down-day pressure, since a price fall may soon occur, and re-purchasing at a lower price.
Moving Averages Strategy
Following a moving average (MA) strategy may be an efficient technical analysis tool to invest effectively. This method observes a predetermined time period and creates updated average stock prices on a rolling basis, smoothing the curve to remove short-term volatility. Shorter MA periods are typically used for short-term trading, and correspondingly long MA periods for long-term trading. A rising MA indicates the stock is in an uptrend and a declining MA indicates a current downtrend. The 50-day and 200-day MAs are commonly used pricing metrics; when 50-day MAs cross above 200-day MAs this indicates bullish upward trends (periods where security prices rise continuously), and the opposite reveals bearish downward trends (periods where security prices fall continuously). Deciding on whether to exit a position can also be supported by trading volumes.
Sentiment Strategy
Sentiment investing focuses on the psychology of market participants and their opinions or beliefs towards a security, or the market as a whole. Participants’ actions are interpreted as a proxy to understand prevailing attitudes in the market. There are a range of action indicators to understand sentiment, for example analysts’ earnings forecasts, changes to institutional investor holdings and market price reactions to news events. Each of these, and many others, contribute to the market sentiment towards a particular security, which can be a useful gauge of which direction prices will move in.
Conclusion
The investment environment has developed significantly in the last 100 years, with changes to technology having a positive influence on methods of analysis and tools used to facilitate this. Accordingly, there is a range of investment strategies developed from earlier and newly created practices. An investor’s preferred strategy will depend on multiple factors and personal preferences. However, there is no one-size-fits-all method, and using a single strategy, or a combination, accurately and effectively can produce quality returns.
You can build and automate your own personalised investment strategies, such as Momentum, in the Stratiphy app, and with a lot more coming soon! You can join our waiting list today to be amongst the first to get access.
Capital at risk. Past performance is not indicative of future performance.This information is for educational purposes and does not constitute advice nor a recommendation.