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Investing is one of many ways to ensure financial security in the present and future. Investing helps investors preserve their wealth against inflationary forces — the erosion of purchasing power due to economic growth.
What and who are investors? Is there a best way to invest? Today we will explore the definition of an investor, discuss the different investing styles, and which of the strategies might be best suited for you.
What Is an Investor?
An investor is a person or an entity that employs capital into assets to achieve financial returns in the future.
Investors usually use a combination of financial instruments to earn a rate of return, usually measured on an annualized basis.
Investors use a plethora of techniques to analyze and value the assets they are keen on investing in. The common goal for investors is to maximize returns while minimizing risks.
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Most investors have their own unique investing characteristics that can be broadly categorized. For example, investors can have different risk-reward profiles, styles, time frames, and capital.
Some investors seek high returns and don’t mind the higher risks that come with them, whereas others seek modest gains in exchange for more security.
High-risk investors may focus their investments in vehicles such as options, stocks, and futures, while conservative investors focus their capital on ETFs and bonds.
The most common misconception about investors is their muddled association with traders. Investors typically seek to remain invested in their choice of assets over long periods of time — years or decades.
Traders have a shorter outlook with time, seeking to make profits within a day (day trader) or up to several weeks (swing trader).
Examples of institutional investors are financial firms or companies that develop mutual funds. Mutual funds use money pooled from other investors, both small and other institutions, to invest in a collection of stocks and other investment vehicles.
For that reason, institutional investors have greater market power and often have more influence over the market compared to individual investors.
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Types of Investors
As we alluded to earlier, investors are a diverse group. Here are the different types of investors. And remember, this is not an all-inclusive list. There are many types of investors.
Pre-investors are individuals who have not started investing. They are individuals who have minimal financial awareness who value consumption over saving and investing.
It is estimated that 54% of U.S consumers are living paycheck-to-paycheck. Among them, 21% struggle to pay their bills.
Pre-investors are usually those who have not being exposed to the concept of financial literacy — a set of skills that allow an individual to make sound decisions with their financial resources.
Perhaps some of them don’t see the value in saving or investing because of the you-only-live-once mindset.
However, there seems to be a growing need to invest in retirement savings. Our research indicates that only 26% of Americans near the retirement age had enough savings for retirement, while 60% say that they don’t think their savings will last them through retirement.
A passive investor cannot or does not wish to devote their time or resources to managing investments. This means they passively invest their capital into various assets.
They limit themselves to a few transactions within a portfolio, which makes it a cost-effective strategy.
Making fewer transactions means that they look to invest in a financial instrument over a long period of time. Employing the “buy and hold” strategy and mindset allows them to focus on other aspects of their life.
Investing in funds provides a simple way to diversify investments, spreading the risk of investing in any securities within the fund. This reduces the time required to research and look for individual securities to invest in.
For this reason, passive investors are more likely to invest with ETFs, index funds, and mutual funds.
ETFs and mutual funds provide ways to invest in various securities according to the sector, geographic location, and asset class.
Stock market indices provide a benchmark for stock market returns, and index funds track the performance of indices, such as the S&P 500 or the Russell 3000.
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Active investors, as the name might suggest, manage their portfolios more actively. This is more commonly referred to as active investing.
They conduct more transactions within their portfolio to beat the average stock market returns derived from stock market indices.
Active investors concern themselves with deeper analysis and require some level of expertise to make their trades. They use their skills to take advantage of price fluctuations to get in or out of a position.
Portfolio managers (or Financial Advisors) are prime examples of active investors whose job is to manage portfolios on behalf of their clients.
Portfolio managers look at quantitative and qualitative data to make educated guesses about the trajectory of a financial instrument in light of the overall economic situation.
What Type of Investor Should You Become?
Risk is usually correlated to reward — the way to more rewards usually involves taking higher risks.
Therefore, there is no clear winner between the active versus passive investor debate. Instead, it is entirely dependent on how you want to approach your investments.
That being said, if you are a pre-investor, adopting a passive style of investing might provide a good starting point.
Active vs. Passive Investors
Passive investing tends to be the more cost-effective strategy; investors with small capitals might benefit from investing passively.
The most common and simplest approach to passive investing is dollar-cost-averaging into funds and tracking their performance over time.
However, passive investors tend to see smaller returns and have limited control over their investments since they focus on funds.
Active investors stand to gain more in returns because they have the flexibility by investing outside of funds.
However, it takes confidence in their expertise and research to carry out those investments. It is also more expensive to trade actively because fees are associated with each transaction made to purchase securities in most brokerages.
Active investors also can hedge or perform actions to offset the risk of any adverse price movements using derivatives, such as options.
Both strategies have their own way of being tax efficient. Passive investors hold positions for long periods of time, thus avoiding massive taxes on capital gains per year. Active investors can reduce taxes by selling out on losing positions.
Is It Better to be a Passive or Active Investor?
Despite the potential of making more money with active investing, most active investors do not consistently beat the market’s average returns.
One study found that up to 82% of investors do not beat the market. One of the most successful investors, Warren Buffet, has been a long advocate of passive investing with index funds for this reason.
Younger investors may engage in active investing for the possibility of outperforming the market, considering that they have the leeway to make mistakes and regain their financial losses with time.
However, the style of investing is defined by the personality of the investor. Some basic things to take into consideration are your interests and willingness to keep up with financial news.
For example, passive investing may be better for you if your goal is simply to outpace inflation.
>> More: Active vs. Passive Investing
Bottom Line: What Is an Investor?
An investor is a person or an entity that deploys its capital in assets with the hopes of receiving a financial benefit in the future.
There are two main styles of investing, each with its own merits and downsides. If you’re just starting, passive investing may be a good strategy to practice while you gain more knowledge and experience in investing.
Ultimately, the ideal investing style depends on your desired level for risk-reward and the amount of time you’d like to spend managing your investments.