Active or Passive Management
In determining investment style, an investor should first consider the degree to which he
believes that financial experts can create greater than normal returns. Investors who want to
have professional money managers who can carefully select their holdings, will be interested
in active management. Actively managed funds typically have a full-time staff of financial
researchers and portfolio managers who are constantly seeking to gain larger returns for
investors. Since investors must pay for the expertise of this staff, actively managed funds
typically charge higher expenses than passively managed funds.
Some investors doubt the abilities of active managers in their quest for outsized returns. This
position rests primarily on empirical research which shows that, over the long run, many
passively managed funds earn better returns for their investors than do similar actively managed
funds. Passively managed funds have a built-in advantage that since they do not require
researchers, fund expenses are often very low.
Growth or Value Investing
The next question investors must consider is whether they prefer to invest in fast-growing firms
or underpriced industry leaders. To determine which category a company belongs to, analysts look
at a set of financial metrics and use judgment to determine which label fits best.
The growth style of investing looks for firms that have high earnings growth rates, high return
on equity, high profit margins and low dividend yields. The idea is that if a firm has all of
these characteristics, it is often an innovator in its field and making lots of money. It is
thus growing very quickly, and reinvesting most or all of its earnings to fuel continued growth
in the future.
The value style of investing is focused on buying a strong firm at a good price. Thus, analysts
look for a low price to earnings ratio, low price to sales ratio, and generally a higher
dividend yield. The main ratios for the value style show how this style is very concerned about
the price at which investors buy in.
Small Cap vs. Large Cap Companies
The final question for investors relates to their preference for investing in either small or
large companies. The measurement of a company's size is called ‘market capitalization’ or
‘cap’ for short. Market capitalization is the number of shares of stock a company has
outstanding,multiplied by the share price.
Some investors feel that small cap companies should be able to deliver better returns because
they have greater opportunities for growth and are more agile. However, the potential for
greater returns in small caps comes with greater risk. Among other things, smaller firms have
fewer resources and often have less diversified business lines. Share prices can vary much
more widely, causing large gains or large losses. Thus, investors must be comfortable with
taking on this additional level of risk if they want to tap into a potential for greater
returns.
More risk averse investors may find greater comfort in more dependable large cap stocks.Large
cap companies may be unable to grow as quickly, since they are already so large.However, they
also aren't likely to go out of business without warning. From large caps,investors can
expect slightly lower returns than with small caps, but less risk, as well.