Theinvestment strategy is defined as a set of rules and procedures aninvestor follows when investing in a portfolio. It can be passive oractive. A passive investment strategy uses exchange-traded fundswhile an active investment strategy requires an investor to chooseactively traded stocks. Here, the goal of the management is to beata particular set benchmark. The active investment strategy isimportant in that management can outperform the set benchmark and arerewarded for their exemplary and superior skills. Management canalso make informed investment decisions based on their experience inthe stock market. Active investment strategies also enablemanagement to reduce the effect of portfolio risk. The disadvantageof this investing is that it is more costly as compared to thepassive one since management has to incur higher fees and operatingexpenses. When managers in this active investment strategy want tooutdo the index, they may concentrate on portfolios with fewer risks.This may make them underperforms the market. Their management styleconcerning the investment portfolio may not favor the market, whichcould lead to lagging performance of the organization (Guy, 2013).
Passiveinvestment strategy on the other hand closely matches the index. Itrequires little decision making by managers. Here, the manager triesto duplicate the index while tracking it as efficiently as possibleresulting in low operating costs on the part of the investor. Apassive investment strategy will never outperform the index but triesto track it. However, this type of investment strategy does not lackits challenges. One is that performance is indicated by index andthat investors must be satisfied with the returns so that it cansucceed. In passive investment strategy, management lacks controlover the index. They are hence prohibited from using defensivemeasures (Investorguide.com, 2009).
Acompany can engage in a passive investment strategy where the indexmatches with that of the market. In this strategy, a company can usesurplus funds to invest actively in the investment strategy option. Surplus funds are retained earnings of a company or cash flowsavailable after a company has paid off all its taxes for a particularproject. To utilize these funds effectively, a company has toanalyze the market whether risky or not. A company also ought tocalculate the risk involved and the costs and profits to be realizedwhen implementing the investment strategy. Lastly, a company caninvest and control the strategy. Here, management can control thecosts incurred when investing in the strategy and can reduce the riskof the investment strategy.
Apassive investment strategy is also known as a buy option. Here,passive investors buy the stocks and bonds but they have no aim ofmaking a short-term profit. Their aim is to eliminate risk and havetheir investment portfolios earn a profit in the end. The passiveinvestment strategy is risky since management sets its stock pricesabout the market index. Their stock prices are lower or at the samelevel as the market but they cannot exceed the market index. If thereis inflation in the stock prices and the prices go up, the passiveinvestor buys stocks and bonds that are of slightly lower than themarket. When an investor buys and later sells the bond, he may incurlosses or gains upon maturity. An investor can invest in stocks,bonds, mutual funds, money markets account, or exchange traded funds.Here, we will invest in shares and bonds.
Shareis a type of investment in a company where the investor has partialownership of the public traded company while bonds are where acompany acquires a loan from a bank, financial institution or theinvestor and pays it back at the end of a certain maturity date. Inthe shares, the company pays dividends to the investor after everyfinancial period. A share is a passive investment since the investorwill be paid dividends according to the profits of the company. Ifthe company makes high profits, he will receive higher dividends butif the profits of the company are low, he will receive low dividends. A bond, on the other hand, is a passive investment option becauseinterest on the bond ought to be paid in conjunction with the market. For example, if the market interest rate is 12 percent per annum,then the company will pay a similar interest rate or a slightly lowerone, say 10 percent. An example of the passive investment strategyis the Vanguard 500 fund that is an equity mutual fund. Severalcompanies fall under this type of funds such as Barclays GlobalInvestors and State Street Corporation. These programs have a higherrisk than active investment, which is more difficult to control therisk. These types of investors tend to set their prices lower thanthe market, and they only have a goal of making a profit in the end. This type of investment strategies and options are often risky asprices may be too low when a country is facing depression.
Thistype of passive investment strategy is different from active as risksare often lower, and investors wish to make a profit in the shortrun. The stock prices of this strategy are often high, and investorsare likely to realize more profits than the passive investmentstrategy. Here, the investor can get excess returns by anticipatingthe short-term investment market trends of the shares. Investors inthis type of strategy believe that price movement is predictable andthat stock markets correlate. Correlation implies that there exist arelationship between these stock prices and that each variable isdependent on the other. For example, future stock prices aredependent on past stock prices. A passive manager relies on thefundamental analysis of a company on the securities such as whendeciding whether they should sell or buy the stock. This type ofinvestment strategy tries top evaluates the investment’s long-termpotential. An active manager, on the other hand, detects andevaluates short-term trends in a share. By doing this, he cananalyze how stocks will be in the near future for a particularcompany. Here, he is more likely to use leverage because they aremainly concerned with mitigating short-term risks and evaluatingshort-term gains.
Imay decide to invest in the stock exchange market let us say theLondon Stock Exchange market. When starting out, I would buy onemillion shares in Watson Petroleum Company, a publicly tradedcompany. I may either decide to invest in an active strategy or apassive one. These two types of strategies have features anddifferences. An active investment strategy or a portfolio managementstrategy has numerous features. One is that active managers try topurchase stocks that are undervalued and short selling them. Theyalso serve to create less volatility by reducing the risk level ofthe investment portfolio. This reduction in risk often creates aninvestment return that is often higher than the benchmark. Here,managers use analytical review procedures to evaluate the portfolioand the risk associated with it. An example is where they use theprice-earnings ratio to find out the maximum returns they will rip inan investment portfolio. They also try to anticipate long-termmacroeconomic trends such as housing stocks and purchasing stocks ofcompanies selling at a discount or whose shares are temporarily outof value. They often pursue risk arbitrage system, asset allocationand option writing (Investopaedia.com, 2011).
Passiveor an investment buyout option, on the other hand, is where passivemanagers buy stocks that are overvalued and later sells them at ahigher premium. They invest in shares that are more volatile andrisky since they perceive that eventually they would generate morereturns. The increased risk sometimes will generate returns andprofits are higher than the benchmark or the index. The managershere do not try or plan to evaluate the riskiness of the portfolio. They invest in the portfolio without regarding the risk involved. They, however, anticipate short-term macroeconomic trends andshort-term profits and returns on their investment portfolios. Passive investment strategy often favors investors, as most marketstend to fluctuate (Takahashi, 2013).
Anefficient market hypothesis is a concept in portfolio managementwhere market equilibrium prices fully reflect all information in themarket or some information may not be reflected. In this case,nothing can be done to exploit the information. A hypothesis can beweak, semi-strong or strong. A weak form efficient market hypothesisfocuses on past data of stock prices. If the hypothesis is correct,it is possible to predict future stock prices. A semi-stronghypothesis focuses on the present and past data. Share prices hereare mainly affected by stock splits, the death of the CEO of acompany, investment in major profitability projects and other changesin dividend policies. This concept suggests that it is impossible tobeat the market. This implies that share prices cannot be higher thanthe market. They can only be lower or at the same level. This systemutilizes the concept of active management where share prices cannotbeat the market. It also prefers non-risky investment strategies oroptions, as information is more volatile here. The efficient markethypothesis is similar in that prices are in conjunction with thebenchmark. Managers in both strategies also try to mitigate risk andare often afraid of the damages and the losses associated with thesesstrategies. The aim of managers in both strategies is to safeguardcompany assets and to mitigate short-term risk and attain short-termgains (Burton, 2007).
Theefficient market hypothesis utilizes the random walk theory wherecurrent stock prices fully reflect available information in themarket. Many investors invest in undervalued securities, which areexpected to increase in value shortly. They often try to outperformthe market and use valuation and forecasting techniques to aid in thedecision-making process. This market is effective since the benefitsgained from the investment does not exceed the transaction andresearch costs. The key reason for the existence of this type ofmarket is the intense competition between investors to realizeprofits. They often try to purchase stocks that are over orundervalued (Burton, 2007).
Anexample of an active investment strategy is Westmont Petroleum whilethat of an efficient market hypothesis is the competitor of Westmont,Watson Energy. Watson and Westmont are often two competitivecompanies where Watson is the leading with high profits and Westmontis the second largest service provider of energy and petroleumproducts. Watson has a current ratio of 1.2 which is higher Li ratiothan Westmont of 0.8. This favors investors making them want toinvest in Watson. The company has also been realizing constantgrowth rate in profits as compared to its competitor, Watson. Theonly challenge it faces from Watson is the constant provision of highquality and differentiated products and services. With regards tothese two companies, investors are likely to face more risk ascompared to those of Watson as the profits and returns of the companyare always fluctuating. Considering the liquidity and profitabilityratios of these two companies, Westmont is more likely to beperforming better as compared to Watson. It has a higher acid testratio of 1.9 as compared to that of Watson. A current asset ratio 1.2as compared to that of Watson of 0.8 and a higher profit margin ratioof 33% as compared to that of Watson of 19%. Since investing inWestmont is riskier in that it has a higher credit risk as comparedto Watson which is moderate, an investor should implement an activeinvestment strategy while an investor from Watson should implement anefficient market hypothesis. When creating my investment strategy, Iwould consider the risk level of the investment portfolio. I wouldalso consider the returns I would rip. I would look for a companythat has higher profit and returns.
Theactive investment strategy applies to companies that have highlyrisky portfolios and are concerned with long-term profits. Thepassive investment strategy applies to companies that try to mitigateriskiness of investment portfolios. They are also more concerned withshort-term gains of the investment portfolios. Watson is an exampleof a successful, efficient market hypothesis or a passive investmentstrategy. It has been successful because it has always analyzed itsmarket before venturing into an investment portfolio. It is alwaysoptimistic of the future, and it has always taken risks no matter theconsequences. Watson has also attracted more investors due to itsstrong hold in the petroleum industry. It has constantly madeprofits and has always paid its investors no matter the liquidity ofthe company. Westmont also ventured in the passive investmentstrategy, but it constantly made losses. This is because theirinvestors are risk averse. The management has to analyze the riskbefore it ventures into the investment portfolio. After realizingthat it could not do well in this investment strategy, the companydecided to venture into the active investment strategy (Theodore,2001). Due to the riskiness of its portfolios and the ability of themanagement of Westmont to analyze the risks, evaluate the costs andthe ability of the portfolios to make profits, it became successfulin the active investment strategy (Brown, 2010).
Sharesmostly suit an active investment strategy as the benchmark may risemaking investors get more dividends. They are also risky in that thestock price may fall below the market making investors get lowdividends. Bonds, on the other hand, suit an efficient markethypothesis. This is major because bonds realize high returns whenthey are in a portfolio with low risks. When an investor is surethat he will get higher returns, he may inject a bond into aninvestment portfolio but if he were unsure, he would rather choose tobuy shares in a company. Before creating an investment strategy, afirm analyzes the market and what option it wishes to get funds from. Let us talk about shares. They write up memorandum and article ofassociation and state the amount they wish to issue to the public. They later draft a prospectus and Gazette it or notify a broker toissue it to the public on their behalf and get a certain commission. After issue, a prospective investor notifies the company that hewishes to buy the shares, and a sale is made. This is majorly in apassive investment strategy. In an active investment strategy, aninvestor must analyze the risk level before buying the shares (Weber,2002).
Tosum up, an active investment strategy and passive investment strategyhave different advantages and disadvantages. Investors usingdifferent strategies in investment in a different situation couldreduce loss to realize maximum profit. An investor may invest in anactive investment strategy is risk averse and wishes to rip long-termbenefits. A passive investor, on the other hand, likes riskyprojects and always evaluates the portfolio risk level. His main aimrealizes short-term gains. Also, He always considers the mostprofitable investment portfolio. Before investing in a company, aninvestor will consider the risk level of the portfolio, theliquidity, and profitability of the company. If the investor’smain aim is to profit in the short run, he ought to decide hisinvestment strategy wisely. If he is afraid of risk, he ought toconsider the most appropriate investment strategy (Swedroe, 2008).
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