I’m a big proponent of index investing and the idea of building a low-cost, globally diversified portfolio using index funds and ETFs. But many investors are drawn to stock-picking and want to outperform the market as an active trader. Fair enough. I’ll explain the type of stock investment strategies that can lead to outperformance.
1. Factor Investing
Let’s start with the idea of factor investing, which shows that certain types of stocks have been proven to deliver higher expected returns due to their exposure to additional risks. These risks include:
1. Market: Stocks have earned a return above the risk-free rate.
2. Value: Inexpensive stocks have earned a return above expensive stocks.
3. Size: Stocks of small companies have earned a return above stocks of large companies.
4. Momentum: Stocks with strong recent performance have earned a return above stocks with weak recent performance.
5. Low volatility: Stocks with low volatility have earned higher risk-adjusted returns than stocks with high volatility.
6. Quality: Captures excess returns to stocks that are characterized by low debt, stable earnings growth, and other “quality” metrics.
With these factors in mind, we could design a stock investment strategy that aims to capture excess returns to the broader market. Investors can use a stock screener to find stocks that fit one or more of these criteria.
You can use the factors to distill down and identify a handful of stocks that have the characteristics needed to outperform the market. But investors don’t need to screen for all the factors when building their portfolio of stocks. They can be used independent of each other, depending on investor preference.
For example, while smaller cap companies may outperform large companies over the long term, it’s likely more difficult to identify individual small-cap stocks than it is to select large cap, blue-chip stocks that meet the other factor criteria. Some investors are just more comfortable investing in companies they recognize and understand.
Factors aren’t a panacea. They’re used to explain the difference in performance between stocks. But the risk premiums for small-cap or value stocks might be difficult to capture in just a few years. Factor investors need the patience to stick with their strategy over a decade or more to see the risk premiums play out.
2. DCA Investing (Dollar-Cost Averaging)
Dollar-cost averaging is an investing strategy aimed at reducing the volatility on large stock purchases. It allows investors to get into the market in smaller tranches over a longer period of time. For example, an investor with a lump sum of $100,000 may not want to put everything into the market at once, and so with a dollar-cost averaging approach he or she may invest $25,000 every three months in hopes of reducing the impact of volatility.
Although studies show that investors would be better off 2/3 of the time putting their lump sum to work all at once, dollar cost averaging has a positive behavioural effect. It allows investors to sleep better at night by investing smaller amounts over time.
Finally, dollar cost averaging is a great strategy for investors who contribute small, frequent amounts to their investment accounts. Rather than waiting until they have a substantial amount saved, investors can get into the market in smaller amounts – say $100 at a time – and start to earn a return on their investments. Dollar-cost averaging makes the most sense when using an online brokerage account such as Questrade, which allows investors to buy ETFs at no charge. It also helps that Young & Thrifty readers get 50 free trades when they open an account.
3. Buy and Hold
Warren Buffett once said, “Our favourite holding period is forever.” Buy and hold is a strategy that involves buying stocks, mutual funds, or ETFs and holding them for the long term. It’s based on the concept of market risk, or stocks for the long run, the idea that equity markets deliver the highest rate of return despite periods of volatility or decline.
Buy and hold investors also recognize that market timing (buying low and selling high) does not work in practice, so it is better to simply buy and hold one’s investments. Buy and hold investors typically prefer blue-chip stocks with characteristics commonly seen in the quality and value factors.
4. The Dividend Approach
Dividend-paying companies tend to be value stocks, with low debt-to-equity ratios and strong profitability. While it’s these factors that explain their outperformance, not the dividends themselves, investors can do well with a diversified portfolio of blue-chip stocks with a long track record of paying dividends and even increasing them regularly. This investing strategy is easy to understand, but there are several variations:
Dogs of the TSX: This stock-picking strategy invests in the top 10 dividend-paying stocks by yield, and then reconstitutes them every year – selling those no longer in the top 10 and replacing them with new high-yielding stocks. The idea is that these stocks tend to be unfairly beat-up the previous year, forcing down their price while driving up their yield. As the stocks revert to the mean, investors can see large outperformance.
Dividend Aristocrats: This strategy invests in companies that have raised their dividends for five consecutive years or more (in Canada), or the more stringent 25 years or more (in the United States). Studies have shown that dividend growth stocks have outperformed the broader market over the long term.
5. Swing Trading
Not for the novice investor, swing trading uses technical analysis as a means to identify trading opportunities and capture short-term gains from stocks on the upswing. Investors create a set of rules to determine when to buy and sell a stock, often holding for a period of just a few days to several weeks.
Technical analysis uses patterns in market data to identify trends and make predictions. The goal in swing trading is to identify a pattern where a stock is due to breakout, buy into that stock, hold for the upsurge, and sell at a point of resistance.
Swing traders who stick to a rules-based methodology can capitalize on short-term swings in the market. But analyzing charts can be difficult and risky when the breakout pattern doesn’t emerge as predicted. However, by sticking with stocks identified as having the momentum factor, swing traders can at least be confident they are investing in stocks with a positive risk premium.
Do-it-yourself investors have plenty of stock investment strategies to choose from. If you’re learning how to invest and looking to build your own portfolio of stocks, consider the factor method described here, as it’s the best stock buying strategy.
You’ll need a discount brokerage account to get started, so take a look at our Ultimate Guide to Canada’s Discount Brokerages. But here’s the spoiler: we’re partial to Questrade, Canada’s king of low-cost investing, where Young & Thrifty readers can get 50 free trades when they open an account.
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