Any investor who sincerely works towards making the most of the current market trend will never underestimate the importance of having an investment strategy predefined before he starts investing. Investment environment is increasingly becoming complex and encompass various kinds of marketable securities. Nevertheless, importance of a well-defined and suitable investment strategy cannot be underestimated.
An investment strategy defines how an investor should go about choosing securities to invest in. It is a basic guide for where to invest, when to invest and how much to invest. There are five important steps in an investment process which should not be neglected. They are:
1. Defining an Investment strategy/policy
2. Analyzing securities
3. Constructing a portfolio to minimize risk
4. Evaluating the performance of the portfolio, and
5. Revising the portfolio
An investor cannot define his investment strategy unless he defines his investment objective and investment surplus to his disposal. Objective of ‘making more money’ is very vague. Of course everyone wants to make more money! Objectives have to be clearly defined in terms of risk and return. Understanding the relationship between risk and return will go a long way while building a portfolio that can provide optimum returns for the amount of risk an investor can take.
A commonly neglected aspect while choosing a venue of investment is the individual tax status. It does not make sense for a tax-exempt investor to invest in government securities or other tax-exempt investment options.
The second step of analyzing securities enables the investor to distinguish between underpriced and overpriced stock. Return can be maximized by investing in stocks which are currently underpriced but have the potential to increase (remember buy low sell high). There are two approaches used for analyzing securities; Technical analysis and Fundamental analysis.
Technical analysis involves studying the trends of stock prices movements. Technical analysts claim that by studying recurring trends and patterns in price movements it is possible to predict near term price movements. This is based on the assumption that price trends and pattern repeat themselves.
On the other hand, fundamental analysts believe that intrinsic value is equal to the present value of all the cash flows that a firm expects to gain in the future. Present value is therefore computed by forecasting the timing and amount of future cash flows and discounting these by applying an appropriate discount rate. A stock is considered undervalued and worth investing in only if this intrinsic value is reasonably less than the stock’s current market price. This is based on the belief that mispriced stocks will be corrected by the market at some point of time in the future, and that underpriced stocks will appreciate and overpriced stocks will depreciate.