The ultimate goal behind any investment is to make money. Using blanket investments like index funds allows just that. In fact, iconic investor Warren Buffett strongly suggests using low-cost index funds to the majority of investors.
But there’s one big problem with these investments. You will never beat the market if you simply mirror the market.
Index funds that give you access to the entire market are so diversified that they effectively mimic the market. For many, that’s great. Average annualized returns near 10% are compelling but, for some, they’re not enough.
Although a common myth suggests that it’s impossible to beat the market, that myth has been busted. Plenty of investing experts beat the market all the time. So, how do you go about generating returns that outpace those of the S&P 500, Nasdaq, or Dow Jones Industrial Average? You use a successful strategy.
The best investors are capable of setting emotions aside and strictly adhering to a predetermined strategy. These strategies outline what types of stocks to buy, when to buy them, and when to sell them for maximum returns.
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Investment Strategies to Use to Beat the Market
If you’re looking to beat the market, there are several strategies you can choose from. With so many options, making a choice can be an intimidating process. Some of the best strategies for beginners to consider include:
1. Timing Cyclical and Noncyclical Investments
Cyclical stocks are investments that have a strong correlation to the economy. When the economy is growing, cyclical stocks will follow. When economic conditions falter, cyclical stocks will see declines.
Noncyclical stocks are those that do not have a strong correlation to economic conditions. These stocks tend to follow more stable growth patterns, offering a safe investment choice during tough economic conditions.
By taking the time to keep track of what is going on in the U.S. economy, you have the ability to make educated decisions as to when to move from cyclical to noncyclical investing and vice versa.
How to Time Cyclical and Noncyclical Investments
To do so, watch the news and pay attention to economic indicators like jobs reports, GDP updates, and oil price updates, which all tell you about the state of the economy. When economic conditions are recovering from a recession or expanding, cyclical stocks are going to rise. As a result, it’s time to pour your investing dollars into strong names in cyclical sectors to take advantage of the run.
Conversely, when economic conditions seem to peak — meaning jobs reports are down, oil prices are down, and the news suggests that tough times may be ahead — it’s time to sell your positions in cyclical stocks and look for noncyclical investments.
While noncyclical stocks may also see slight declines, the declines are generally much smaller than you would see with cyclical stocks. To add icing to the cake, most noncyclical stocks pay decent dividends, often adding enough to your overall returns to help you beat the market.
Pros & Cons of Timing Cyclical and Noncyclical Investments
No matter what strategy you deploy in your effort to beat the market, there are going to be pros and cons to consider. A strategy centered around the timing of cyclical and non-cyclical investments is no different.
Pros of Timing Cyclical and Noncyclical Investments
The timing of cyclical and noncyclical investments is a popular strategy among expert investors, and for good reason. It works. Some of the key benefits associated with this strategy include:
- Compelling Profit Potential During Positive Economic Conditions. Cyclical stocks are defined by their correlation with the state of the United States economy. When economic conditions are positive, these stocks realize gains, while losses are realized when economic conditions are negative. However, the movement in either direction tends to be momentous. As a result, when economic conditions are positive, investments in cyclical stocks offer the opportunity to tap into significant gains.
- Safety During Times of Economic Unrest. This strategy suggests that when economic conditions are negative, cyclical stocks are sold, and noncyclical stocks and other noncyclical investment vehicles are purchased. Noncyclical stocks are known for slow, steady upward movement. While they may take a dip during tough economic times, they are far better at holding substantial portions of their value than cyclical stocks. As such, this strategy offers an umbrella when there are clouds over Wall Street.
- Buy and Sell Signals Are Relatively Easy to Read. This strategy surrounds buying and selling stocks at the right time, and timing can be difficult. However, because the strategy is centered around economic conditions, determining when to buy and sell is quite a bit easier than making that determination when following other strategies to beat the market.
Cons of Timing Cyclical and Noncyclical Investments
Although there are plenty of benefits involved in timing cyclical and noncyclical investments, the strategy also comes with its fair share of drawbacks. The most important cons to consider if you’re thinking about deploying this strategy include:
- Timing the Market is Risky. The strategy of timing cyclical and noncyclical investing has timing in its title. However, attempting to time the market can be a risky proposition. Although the correlation between these types of stocks and the economy makes timing easier, it’s still a risky concept, as making an ill-timed move when deploying this strategy has the potential to lead to significant losses.
- Economic Analysis is Difficult. This strategy also requires the investor to consistently analyze economic conditions. After all, if you get caught holding cyclical stocks through an economic decline, you’ll be licking your financial wounds in the end. Like the stock market, the economy is an intricate topic with several working parts. Timing trends in economic conditions is difficult, even for the most seasoned economists.
- Not a Good Option for Income Investors. Although noncyclical stocks are known for paying strong dividends, economic conditions are positive the majority of the time. So, if you follow this strategy, you’ll be investing in cyclical stocks the majority of the time. Unfortunately, cyclical stocks are known for paying little or no dividends. So, if your income depends on your investment activities, this isn’t a good option for you.
2. Combining Growth and Dividends
Most people don’t talk about growth stocks and dividend stocks in the same sentence. The vast majority of stocks belong in one group or the other. Growth stocks have the potential to generate tremendous runs in value over a short period of time. Conversely, dividend stocks generally see slow, steady growth, making up for the difference in dividend payments.
Very few stocks represent a strong growth opportunity while also paying decent dividends, but that doesn’t mean they don’t exist. Finding these stocks may be like finding a needle in a haystack, but you can find these gems with enough research, and it can pay off big time.
In particular, look for stocks that have two key characteristics:
- Growth. The stocks you should be paying attention to should have an average annual rate of return of 15% over the past three years.
- Dividends. The stocks you will choose for this strategy also pay a dividend yield of at least 3%.
How to Find High-Growth, High-Dividend Stocks
In order to beat the market with high-growth dividend plays, you’ll need to find the stocks that fit into that category. There are four steps to doing so:
- Find Growth Stocks. You’ll need to start by finding stocks that meet half of the requirement you’re looking for — generating growth. One of the best tools for doing this is Yahoo! Finance. The website allows you to build your own stock screeners. There are two premade screeners for growth stocks. They include undervalued growth stocks and growth technology stocks. Both of these list stocks that experience revenue and earnings growth of 25% or more.
- Look Into Annual Return Rates. Now that you have a list of stocks to dig into, it’s time to look into annual growth rates. Go through the stocks on these lists one by one and find those that have an annual rate of return of 15% or better. Make a list of all of the stocks that meet this criteria.
- Check Dividends. Next, it’s time to dig into dividends. The vast majority of companies on your list at this point will not pay dividends. Don’t get discouraged if you look through five or six and don’t find a single dividend payer. Keep digging. Eventually, you will find a few stocks on your list that pay dividends with a yield of 3% or more.
- Rinse and Repeat. Continue the process until you feel you have enough stocks on your list to provide high-growth, high-dividend opportunities, with enough diversification to protect you from significant losses in any individual stock.
Pro tip: Stock screeners are a great way to find different companies that meet your investment requirements. We’ve put together a list of the best stock screeners available.
Pros & Cons of Combining Growth and Dividends
As with the timing of cyclical and noncyclical stocks, there are plenty of benefits to combining growth and dividend stocks. Of course, the strategy also has its fair share of drawbacks to consider.
Pros of Combining Growth and Dividends
Combining growth and dividend stocks can be an overwhelmingly lucrative move. Not only do you benefit from the growth involved in picking stocks that are seeing compelling movement, you also ice your cake with the dividends paid through these investments. Some other perks to deploying this strategy include:
- Safety. Stocks that are known for paying high dividends are some of the safest stocks on the market today. In order to meet their dividend obligations, these companies have to have a grip on their respective markets and the profits they will make. As a result, companies that have reached this level of success offer up some of the more stable stocks on the market, shielding you from significant losses.
- Income. This strategy combines two styles of investing — growth investing and dividend investing. Dividends are a form of income, and picking stocks that pay high levels of dividends can result in substantial income over time. Because this strategy provides a high level of income, it is a great strategy for those nearing retirement, retirees, or anyone else who wishes to produce significant income through their investment portfolio.
- Consistent Growth. Finally, one of the factors that makes dividend stocks such safe investment options is the fact that they are known for generating consistent growth. Many of these companies operate in the utilities and consumer staples sectors. These sectors are known for generating consistent growth because consumer demand for their products and services doesn’t typically falter, even in times of economic unrest.
Cons of Combining Growth and Dividends
Investing in growth and dividend stocks comes with clear perks, but like any strategy, there are drawbacks to consider. Some of the most pressing include:
- Diversification is Difficult. High-dividend stocks aren’t known for producing enormous growth, and growth stocks rarely pay generous dividends. So, finding opportunities when deploying this strategy requires a bit of research, but research isn’t the problem. The problem is that there are so few of these stocks that finding enough of them to properly diversify your portfolio may prove to be troublesome. Because diversification is a crucial protection against significant losses, giving up your ability to diversify is a major risk to consider.
- Consistent Portfolio Balancing is Required. Stocks that produce compelling growth won’t do so forever. At some point, growth will slow down. When it does, you will hit a major bump in the road as your returns begin to slow. As such, you will need to consistently balance your portfolio if you deploy this strategy.
- You Won’t See Much Momentum. Growth and momentum are two different beasts. While the stocks you invest in with this strategy should generate compelling and consistent growth, that growth is more steady, and short-term momentous gains simply can’t be expected.
3. Value Investing
Value investing was the strategy that took famed investor Warren Buffett from rags to riches. The idea is to shop for stocks in the same way you would shop for an expensive product. Most consumers aren’t going to just shell out whatever the first company selling what they want asks for. Instead, people look for discounts.
Value investing is the process of seeking out and finding discounts in the stock market.
How to Determine a Stock’s Intrinsic Value
There are several ways to determine the intrinsic value of a stock. Although each method may give you a different number, none of those answers is wrong — they can all tell you something about the fair value of a stock relative to its current price. Some of the most commonly used ratios to measure the value of a stock are:
- Price-to-Book-Value Ratio. The price-to-book-value ratio compares the price of the stock to the company’s book — the overall value of the company based on its balance sheet.
- Price-to-Cash-Flow Ratio. The price-to-cash-flow ratio compares the price of the stock to the cash flow the company generates. Of course, higher levels of cash flow represent stronger investment opportunities.
- Price-to-Earnings Ratio. The price-to-earnings ratio compares the price of the stock to the amount of net earnings the company generated over the course of the past year.
- Price-to-Sales Ratio. Finally, the price-to-sales ratio compares the price of the stock to the amount of sales generated over the course of the past year.
When using these ratios to determine the intrinsic value of a stock, keep in mind that different sectors will have different averages. So, it’s important to compare the ratios for the stocks you’re interested in to the same ratios for similar stocks within the sector. Also, look through the history of the stock you’re considering. Ideally you’re looking for not only a discount compared to others in the sector, but a discount when compared to the history of the stock you’re interested in.
Investing this way helps to reduce your risk by buying stocks that are trading at a discount. If your evaluation is correct, the potential for the stock to gain is much greater than the potential for the stock to fall. Buying discounted stocks as a value investor and selling as market pricing nears what you believe the actual value of the stock should be can be a highly lucrative process.
Pros & Cons of Value Investing
Successful value investors consistently beat the market. However, value investing isn’t always sunshine and rainbows. Here are the pros and cons that you should consider before deploying this strategy.
Pros of Value Investing
When investing in value stocks, the required research leads to a deep understanding of the investment you’re making, but that’s only one of the many benefits involved in the strategy. Some of the most significant benefits of value investing include:
- Buying a Discount. Value investing involves buying stocks when the market price of the stock is well below where it should be. So, when you buy a value stock, it’s like using a coupon at your favorite retail store. Essentially, the fact that the value of the stock hasn’t caught up to the fundamentals means you get to profit from the difference.
- Low Risk vs. Reward. When investing in a stock that the market has undervalued, there is relatively little risk compared to the potential reward. The idea is that value stocks trade at such a low price, there’s not much room to fall, but there’s plenty of room for gains. That makes for a risk vs. reward profile that’s hard to ignore.
- A Fundamental Approach. Finally, a successful value investor pays close attention to key fundamental metrics like price-to-earnings ratio, price-to-book-value ratio, and more. Doing so gives you an intimate understanding of the investment you’re making and the potential for that investment to either gain or lose. Because educated investments tend to be profitable investments, taking a heavy fundamental approach like this greatly increases your chances of success.
Cons of Value Investing
Value investing is a great way to boost the returns realized in your portfolio. However, value stocks aren’t perfect. There are a few drawbacks to consider with this strategy as well.
- These Stocks Are Difficult to Find. If there were big, bright lights shining on undervalued stocks in the market, everyone would buy them and they would no longer be undervalued. As a result, like finding stocks that experience solid growth and pay strong dividends at the same time, finding undervalued stocks takes quite a bit of research and can be incredibly time consuming.
- Hurry up and Wait. Buying heavily undervalued stocks is a double-edged sword. Sure, you’re getting a discount, but you only realize the value of the discount when the market catches up to the true valuation of the stock. There’s no telling how long that will take. For some stocks, it may be days, weeks, or months, but for others your investment dollars may become trapped on a never-ending road to nowhere.
- Diversification is Difficult. When it’s difficult to find the type of stock you’re looking for, finding enough of them to properly diversify your portfolio is profoundly more difficult. That simple fact greatly adds to the risk involved in this strategy.
Attempting to Beat the Market Comes With Increased Risk
One trait that all of these strategies have in common — other than the fact that they are all designed to beat the market — is an increased level of risk. The fact of the matter is that if it were easy to beat the market, everyone would do it.
Making the wrong move in an attempt to beat the market can prove to be a costly mistake. So, if you hope to employ any of these strategies successfully, you should have the following qualities:
- A Strong Appetite For Risk. Because any attempt to beat the market comes with an increased level of risk, this is only something that should be attempted by investors with a strong stomach.
- A Detailed Understanding of the Market. Performing the fundamental, technical, and economic analysis that’s involved in beating the market requires a detailed understanding of the market and what makes it tick. As a result, attempts at beating the market are best for those with a deep understanding of the investing process and what makes an investment successful.
- The Ability to Check Emotions at the Door. Emotions are the enemy of any trader, but if you’re making an active attempt to beat the market, emotions can become your worst nightmare. Only investors who have the ability to check their emotions at the door and strictly adhere to their trading strategy should attempt to beat the market.
Beating the market is possible, and doing so is lucrative. However, if you plan to try, you’ll need to find the right strategy for you and follow it to the letter.
Oftentimes, investors decide to mix and match strategies. For example, you may decide to take advantage of both value investing and investing in growth stocks with strong dividends in order to meet your diversification goals with strategies that make it difficult by themselves.
No matter how you chose to go about beating the market, always do your research and make educated investment decisions.
Do you consistently beat the market with your investment portfolio? What is your favorite strategy to use to beat the market?