Investing is the act of allocation of capital to produce a calculated return while risking the principal within reason. We all have tried to invest our money into something or are planning to do so. However, not everybody has a clear idea of what an actual investment is. Here, we are not bothered with the definition and criteria, even though, one should be very clear about them before entering into any investment of any type. Here, we focus on the possible approaches to an investment. Investment, just like any other activity in this world, can be done using different approaches and styles.
Investing can be done in many fields using many ideologies. However, all of them can be broadly classified into three styles. Despite the fact that the ultimate goal of investing is to produce a profit, each approach tries to achieve this profit via different sources, in different ways and timeline.
These three styles overlap in many different instances, whether as a result of deliberate actions of the investor or as an accident. It doesn’t mean that one has to choose between one of three and following one is not equal to disobeying the other two. In fact, to have the maximum return and minimum risk, one has to try to mix the three styles.
These three styles act as your guideline for any investing choice that you are about to make in the future, in any field. If an investment cannot be justified by at least one of the three styles, it breaks the fourth law of investment and is either not a profitable investment or not an investment at all.
Value investing is one of the oldest methods of investing and is based on a very simple idea which has quite evolved over the years. Value investing is based on buying an asset with a bargain, at a price considerably lower than the fair market or true or fundamental value. So the concept is fairly simple. In value investing, you evaluate the asset you are about to buy and estimate its market value. If the price that you are about to pay for the asset is less than the estimated value, you are buying the asset at a discount rate and the act is a value investment.
I emphasize the fact that we are estimating the true value. Every good or service is as valuable as someone’s willingness to pay for it. If you have a pair of socks and there are people out there with some kind of a sock fetish, willing to pay you $500 for your not-very-hygienic socks, one is safe to assume that your socks are worth $500. This crazy story actually became reality in 2007 when Britney Spears, the famous pop singer, ran over a photographer’s foot with her car, leaving a tire track mark on his socks. Forgetting about the questionable fashion choices of that photographer, he was working for TMZ, a media company which focuses on the celebrity news. TMZ sold that pair of socks on eBay for $585 and donated all the money to the children’s defense fund. Obviously, the buyer had a charitable intention in the mind but only because someone paid that much of money for that pair of socks, we cannot assume them to worth $585.
The socks metaphor (or reality, in this case) highlights another fact as well. Not every cheap thing is worth investing your money on and if it is not worth it, it is not an investment following the second law of investment. The asset you are looking to buy should have the potential to bring you a return while having a reasonable risk following the third law of investment.
Value investing in most fields focuses on buying something below its fair market value which gives you an immediate insurance and possible profit. Imagine that you buy a $100,000 property at $85,000. This way, if the property prices fall down, your risk is significantly reduced and theoretically, you can sell the property for $100,000 in the next day and have $15,000 in profits.
This style, however, has evolved a lot in the stock market, unsurprisingly, due to its complexity. In the stock market, the value investors, through fundamental analysis, estimate a fundamental value for a company and then compare it with the current share price and market capitalization. If the shares are being traded at a discount rate, the value investors consider the company’s stock. However, a discount rate is not enough for such investors to jump in. They look for a long term investment, having the company and its business in mind while ignoring the market fluctuations and emotions. They look for a business to invest in rather than a price.
Growth style of investment, as the name suggests, focuses on the growth of the underlying asset. The investor would look for something that gains value faster than the average market or other forms of investment.
This style is more usable and practical than any other time in the history due to the faster pace of every industry and field of investment which is mainly due to the advancement of technology.
Even though this approach is practical in every field of investment, it requires a better judgment and expertise compared to the value investing. It is much easier to find a fundamental value for a property and try to buy it at a cheaper price rather than handpicking the one which rises in equity faster and greater than the average market.
This style is the prominent idea behind investing in startups. A startup is a new business and has no actual value since, most likely, it doesn’t have any business yet. So a value investor may stay away from a startup because the price paid is usually higher than the fundamental value. However, a startup can grow relatively faster than any established company. For example, imagine a startup trying to change the world by its new idea. An investor might invest $1 million in the company in exchange for 50% of the company which, through a simple math, implies a $2 million value for the business. After 5 years, the idea of the company turns into the hottest product in the market and the company becomes as famous as it gets. A buyer comes along and offers to buy the company for $250 million. So, our patient investor who owns 50% of the company, will receive $125 million which is 125 times the original investment in just 5 years.
Obviously, no established company will grow 125 times in 5 years. However, not every startup can survive after 5 years and those who do, may fail to grow so fast. The same is true in the stock market where the investors try to handpick the stocks which grow faster than the average market. Many of the private and professional investors, including mutual and hedge funds, are practically using this style due to the short holding period of stocks. Although one can beat the market by handpicking the fastest growing stocks, nobody can be sure. As the result, the risk of this style is somewhat higher than value investing.
So, to produce an actual profit in this approach, you have to follow the laws of investment very carefully, especially the first one. Mixing this approach with value investing can minimize the risk and maximize the capital gains.
This approach is somewhat fundamentally different from the other two. In income investing, the investor is focused on making money while owning the asset while the other two styles of investment focus more on capital gains which are only realized when the asset is sold.
If your goal requires you to focus on the income, you have to find the assets which are able to produce revenue. For example, one of the common sources of income investing is rental properties. Investors would buy a rental property for the revenue they expect to receive from the rent. If you buy a piece of land, you most likely cannot rent it and there will not be any income, obviously. So, the asset that you chose must have the potential to generate revenue.
Back to the complex stock market, things are, unsurprisingly, not so simple. The revenue that one receives from the stocks is not guaranteed. A company can decide to pay dividends in one year and chose to pay nothing in the next. There is no law forcing companies to pay dividends to their shareholders and when they do, it is usually not very significant compared to the original investment. However, income investing is the dominant idea behind bonds where the coupons are determined and somewhat guaranteed unless you buy, say, Venezuelan bonds and if that’s the case, you really have to think about your life choices very seriously!
Well, there is no single best approach. Each one of these styles have their pros and cons and the choice depends on your goals. If you are investing for your retirement or your kid’s college fund, the value investing is the right choice. If your investment horizon is only 2-3 years or even shorter, growth investing is the practical approach and if you want to see changes in your cash flow on a regular basis, you have to focus on income investing.
However, following one style does not require you to unfollow the other two styles completely. You always have to try to mix different styles with your primary approach. If you are focusing on growth, for example, it is really necessary to try to buy the asset at a discount price to maximize the returns and minimize the risk. As another example, you can invest in companies with a good value which are also regular in paying out dividends to increase your profits and allowing you to use some of the benefits while owning the stocks.
Finally, if you cannot determine your goal or unable to chose your primary style, value investing is always the safest method with good results in the long run.