Investment style denotes the overarching approach that investors and fund managers use when assembling an investment portfolio. Familiarity with the major investment styles can help people quickly navigate the myriad of investments offered in today’s market and pick those that best suit their personality and financial goals. Major investment styles most commonly differentiate between active and passive management, growth and value investing, and small-cap and large-cap companies.
Investors who prefer professional money managers to hand-pick their holdings can opt for active management. Actively managed funds usually have a dedicated team of financial researchers and portfolio managers that works full-time to create higher returns for the investors. Their expertise and service come at a price; thus, actively managed funds typically cost more than their passively managed counterparts.
Passively managed funds better suit those investors who question active managers’ abilities to realize higher gains. Empirical research supports their doubts. A 2018 study of the US Federal Reserve System indicated that often passive funds outperform actively managed ones.
The growth versus value differentiation of investment styles relates to companies with quick and high growth potential and currently undervalued but expected to generate superior return stocks. To categorize the companies, analysts examine several financial metrics.
With growth investing, they search for companies with demonstrated high earnings growth rates and returns on equity (ROE). In the investing field, the growth rates typically represent the total annual growth of a company’s revenues and earnings, expressed as a percentage. ROE measures a company’s financial performance. It equals its net income divided by shareholders’ equity.
In addition to these metrics, growth companies should also have high-profit margins and low dividend yields. The profit margin corresponds to the percentage of sales that has resulted in profits. Also expressed as a percentage, the dividend yield denotes the financial ratio dividend-price or the amount a company pays out in dividends annually respective to its stock price.
The logic behind growth investing is that companies that meet these criteria are usually innovators in their field and flourish financially. Thus, they rapidly grow and reinvest most of their earnings to propel future growth.
Conversely, value investing concentrates on buying the stocks of a company with solid positions at a good price. In this case, analysts pick companies that have low price-to-earnings (P/E) and price-to-sales (P/S) ratios and a higher dividend yield. The P/E measures a company’s current share price proportional to its earnings per share, while the P/S evaluates its stock price compared to its revenues.
Finally, the small-cap versus large-cap investment styles relate to whether investors prefer investing in small or large companies, respectively. They measure the company’s size by market capitalization. Market capitalization denotes a company’s outstanding number of shares of stock multiplied by the share price. A public company with a market cap valued between $300 million to $2 billion is considered a small-cap company. Large-cap companies are those with a market capitalization exceeding $10 billion.
Some investors favor small-cap companies because they think they can potentially deliver higher returns due to their greater growth opportunities and agility. But the higher-returns potential comes with higher risk. Smaller companies often lack enough resources and diverse business lines. Their share prices can fluctuate considerably, resulting in big gains or big losses. Therefore, the small-cap investment style is more suitable for investors with higher risk tolerance.
More risk-averse investors should consider investing in well- and long-established large-cap companies that have become leaders in their industries. These companies may have lower growth opportunities, but they are unlikely to disappear from the business scene without warning. The returns on investing in large-cap companies may be slightly lower than those of small-cap ones, but they also come with lower risk.
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