Many individuals identify their investment strategies by what the “experts” say. And a technique called Sector Leaders Strategy would also be advocated by some investment experts, i.e. purchasing shares of the best-performing companies determined by a specific market index that monitors a portion of the stock market. The Standard & Poor 500, for example, is focused on the largest exchange-listed customers.
So to follow the Sector Leaders Strategy, you could invest in an index fund, which aggregates stocks from the 500 biggest companies. Since index funds are calculated automatically and don’t require much human brainpower to run efficiently, they’re cheap to buy and also secure – which makes them an attractive investment option.
You shouldn’t join the herd, though, if you want to earn the highest returns on the money you spend. You ought to be different instead. While index funds tend to produce good returns, they will never beat the market, particularly if they try to match the market index’s returns.
But there’s another reason to consider alternatives to index funds: The biggest companies tend to underperform when they reach the top. For instance, major American companies like Apple and Intel typically start posting a negative annual return once they hit the $400 billion mark. Therefore, investing in these firms may not be the most profitable choice.
By comparison, in order to maximize your returns, you should try to adopt the Sector Bargains Strategy , which means purchasing the cheapest stock, not the best. While it might sound counterintuitive, in the long run, these kinds of strategies always outperform the leading approach. The value of the Russell 3000 (an index fund that follows, more or less, a bargain strategy) has outperformed the S&P 500 by more than 1,100 percent since 1979, for example.
As we’ve already seen, being different is the best investment approach. So let’s examine this principle a little more closely. For our purposes, the ideal investment strategy – let’s call it the Millennial Money Strategy – can be summarized thus: Buy cheap stock from valuable companies.
Why is this the best strategy? Well, by buying a cheap stock (that is, one with a lower share price), you’re stretching your investment and potentially maximizing your future returns.
And as we noted, you’re trying to find a true bargain – not merely the cheapest stock available. So when you’re buying shares, you need to ensure that the company has value and that the (currently low) share price is likely to rise in the future.
To that end, what can you do to assess the long-term prospects of a business? Start by looking at how much the business earns; also pay attention to how much cash it attracts (in some cases, credit or loans actually yield reported earnings). Then, compare the stock price of the company to its cash flow to find the best bargain. Value / valuation is demonstrated by this relationship. In the end, you’re trying to find businesses with a cheap share price and safe finances.
You can also boost this strategy by finding the right momentum and buying shares just as the market notices a company’s potential. An easy way of finding a stock that’s riding a wave of momentum is to look out for cheaper shares that have seen substantial price increases over the last six months.
Ultimately, you should try to carve out an investment approach that combines value-seeking with momentum. And if you need a little more convincing, consider the fact that since 1972, companies that have matched these criteria have grown at an annual rate that outpaces market growth by a factor of two.
Humans are hard-wired to make investment mistakes; essentially, we’re programmed to be irrationally fearful. In fact, it’s even been scientifically proven that we’re subject to something called constructive paranoia – that is, excessive sensitivity to loss.
Consider a study by Stanford that asked learners to make 20 investment decisions. Students had to determine during each round whether they wished to spend $1. The result of the investment was determined by a coin toss: the students lost $1 when the penny came up heads; when it fell on tails, they won $2.50. As it turned out, students were only able to spend 41 percent of the time after suffering a loss. The decision did not make sense, however, rationally speaking, because there was a 50 percent chance of winning a high reward!
This tendency affects the market. For instance, investors often buy at market peaks (for fear of missing out) and sell at market bottoms (because they’re scared of losing everything). So plenty of people irrationally buy high and sell low, contrary to the most basic maxim of stock trading.
But constructive paranoia isn’t the only investing mistake built into our programming: so is greediness. In general, we tend to pursue rewards even when our chances of getting these rewards are dismal.
And in large part, this impulse drives financial bubbles: Even though there’s a strong likelihood that the bubble will burst, people still invest, because they’re blinded by the possibility of future rewards.
While you will never remove your instincts, by designing an automated system, it is possible to isolate them from your investments. You might, for instance, set up an automatic payment into your investment account from your bank account. You will decide the duration and regularity of the advance payment, as well as the money you would like to buy with the money.
So the idea is that once you’ve determined a particular strategy, you should apply it systematically, without letting your instincts get in the way. And having an automatized payment system is one way of doing this.
Sometimes inexperienced investors think they need to sell their shares as soon as they start losing value. And yet, this kind of short-term thinking typically isn’t profitable.
So why in the first place do we go for it? Well, our biology plays a major role: humans have an emotional core located in the brain (the limbic system) that forces us to make decisions that give immediate gratification. This instinct explains why, during times of financial distress, investors prefer buying bonds. Since bonds bounce less than stocks in the short term, in the sense that they shield the investor from dealing with negative figures, they offer immediate gratification. The investor feels that his capital is covered and maintained in that way.
Short-term thinking also afflicts professional investors, who are preoccupied with their short-term career horizons. These professionals often create investment strategies designed to be profitable over a two- or three-year period, in order to demonstrate successful results to current or future employers.
And yet, when we look at the numbers, it’s clear that it takes many decades (around 30 years) for the most profitable investments to mature. What is the reasoning for this? Well, while the market continues to fluctuate a lot, in short-term trends it often moves. Thus, while we often think negatively and prefer to expect economic downturns, the economy generally has a longer-term upward trajectory.
Millennials should start investing in the stock market as early as possible to protect their financial future. There are only a few basic guidelines that contribute to long-term investment success: diversify your portfolio to include stocks across the globe, stick to your plan, and make anti-flow investment decisions.
So give this a try. Make taxes a consideration in the investment you make. When investing, you should pay attention to tax benefits: if you keep your winning / most valuable stocks for at least one year, your income will be taxed at a lower tax rate (long-term tax rate for capital).
Check out my related post: Why should you invest in real estate?