Vanilla strategy refers to a mainstream approach to investment-related decision-making in businesses. The broad characteristics of a vanilla strategy are that it tends to be conservative and practical. Thus, such strategies generally include a minimal degree of risk.
Vanilla strategy refers to a mainstream approach to investment-related decision-making in businesses.
It is fairly common for investors to achieve by sticking to proven strategies, such as passive investing or trading in plain vanilla.
In finance, vanilla strategies generally tend to get outperformed by most short-term investing strategies that are aggressive in nature.
Rationale behind Vanilla Strategies
It is fairly common for investors to achieve by sticking to proven strategies such as passive investing. Passive investing includes strategies such as index-based investing. Here, the investor purchases and holds over long periods of time a representative benchmark, e.g., the S&P 500. Passive investing is also exercised using exchange traded funds.
With the same logic, a business can employ tried and tested strategies to achieve success. For example, they can focus their business line in an area that provides a clear competitive advantage for them. The most common elements of vanilla strategies in business include focusing resources only in areas with strong business advantage, using debt financing in order to fund growth but only at moderate levels, or avoiding dependency on a sole product or client.
In such situations, however, it is also important to ensure scope for innovation as competitive advantages tend to weaken over time as demand for the product or service increases or input prices decrease, etc.
As the name suggests, vanilla strategies are comparatively easy to explain, even to an individual who may be new to finance or business. For example, for an individual interested in building an income portfolio, it is recommended to buy and hold stocks with a steady history of dividend payments to shareholders for about ten years. The future dividends for said stocks will provide a steady income stream for the investor. When compared to an iron condor options strategy, the latter is clearly hard to understand.
Vanilla strategies also include trading in plain vanilla, which refers to the most standard or basic versions of financial instruments, such as bonds, options, swaps, etc. They are different from exotic instruments, which are more complex securities usually created by changing the characteristics and components of traditional financial instruments.
Vanilla strategies became more commonplace in the aftermath of the 2008 Global Financial Crisis. The collapse of the global financial market came about due to the risky mortgages in the US housing market. Thus, policymakers pushed not only for higher regulations in investments in unconventional instruments but also for incentivizing plain vanilla approaches to investments. It means that lenders would be obligated to offer standardized mortgages with a low level of risk.
Example of Vanilla Strategies
Common examples of vanilla strategies include a number of situations, such as where an individual sets aside a given sum of money each year to fund the college education of their child in the future.
Another example is leveraging automatic payroll deductions in order to fund a 401(k) or other retirement accounts. A traditional approach towards mortgage repayment is directing additional funds annually towards the repayment of the principal amount of the loan.
For retirement savings, a vanilla strategy will include saving a given percentage of one’s annual income, e.g., at least 10%, and then investing that amount in a diversified portfolio of bonds, stocks, etc. Usually, it is done using tax-advantaged savings accounts, such as a Roth IRA and 401(k).
Advantages and Disadvantages of Vanilla Strategies
In finance, vanilla strategies generally tend to get outperformed by most short-term investing strategies that are aggressive in nature. Such a fact makes it difficult for investors to stick to vanilla strategies, especially because they usually adopt a long-term investment horizon.
It may not suit the income or return expectations of every kind of investor, which acts as an added disadvantage. However, in challenging markets, aggressive strategies tend to underperform drastically more than vanilla strategies.
CFI offers the Commercial Banking & Credit Analyst (CBCA)™ certification program for those looking to take their careers to the next level. To keep learning and developing your knowledge base, please explore the additional relevant resources below:
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