Sunday, August 5, 2012

The big question: Risk vs Return, Part 3

Generally, there are two ways of approaching stock selection based on their fundamentals.

  1. Value:
    Value companies are those that have a consistent track record of performance. E.g. Coca-Cola, Procter & Gamble ... These companies consistently generate profit, but they have little space to grow. These are sometimes also known as blue chips or dividend stocks. They typically have relatively low Price to Earning ratio, usually below 15.
  2. Growth
    Growth companies, as their name stands, are companies that are regarded to have a lot of potential in the future. They are typically new companies with limited history and possibly limited earning. Examples of this kind would be LinkedIn, Facebook, Salesforce, etc... Some of those companies don't necessarily have a positive income, (Salesforce), but the Wall Street regards them as future cash cows and is willing ignore their current earning. 
The idea is that value stocks should have less risk, less return, higher dividend payment. It's not necessarily true. The Vanguard U.S. Value fund's last 10 years has actually been a wilder ride than the Vanguard U.S. Growth fund, although the value funds dividend yield was indeed almost 4 times higher than the growth fund. 

Personally, I think both strategies make intuitive sense for long term investors, because I believe that in the long run, a company's stock price will be mirroring its performance. But I also think just like anything in investment, you need discipline for any of the strategies to work, since one must not get carried away by chasing "best performer"s. 

Another way of categorizing stocks is U.S. vs International.

Generally speaking, U.S. stocks are less risky for people who reside in the U.S. and spend U.S. dollars. This is because even if all else is equal, U.S. stocks lack any currency risks that foreign stocks inherently have, since they are traded not based on U.S. dollar but local currencies. Foreign stocks can offer higher returns in many occasions, so I would not completely shy away from them. This is true even now with the European turmoil. My international stock investment has returned 10 percent since June 1st, while my U.S. stock investment has returned less than 8%. 

My personal strategy towards equity investment is 60/40 U.S. to foreign. I've gone for passive broadly diversified indices rather than growth or value funds, but in the future, when I get more capital to invest, I think I'll keep passive funds as my equity portfolio core and add some actively-managed growth funds for possibly higher returns. 

In the next post, I'll discuss bonds in terms of risk and return. 

P.S. if you have any questions, you can leave them in the comment section. I'll try my best to answer them, but again, everything is just personal opinion, though I do guarantee you that I put my money where my mouth is. 

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