In this article, I will cover the 5 most common stock market investment strategies, the challenges of each strategy, and which types of investors would be better suited towards a particular strategy. In short, most investors should stick with prioritizing the first three strategies, while more sophisticated/technical investors can consider the last two strategies.
Strategy #1: Passive Investing
Passive investing is strategy that many investors follow, and consists of buying broad-market exchange traded funds (ETFs) or index funds, holding onto them for a very long time, and typically "dollar-cost averaging" the investments.
An ETF is an exchange traded fund. It's a low-fee passively managed fund that tracks an underlying benchmark like the S&P 500, which is a collection of the 500 largest publicly-traded companies in the United States.
To follow a passive investment strategy, you would simply invest $1000 on a regular cadence (i.e,. monthly), or however much you can afford into your ETFs or mutual fund portfolio, regardless of the current market price. By doing this, you would essentially get the "average" price of the market over time, while also not having to worry about the current market environment (as much) or timing the market.
ETFs for Passive Investing
In the past, if you were a passive investor, this meant going to a financial advisor and investing in mutual funds, professionally managed investment funds that use pools of money from investors to invest in assets, in exchange for fees and other expenses.
Although this may seem like a great idea, roughly 1 in 20 domestic large cap mutual funds over the past 15 years have managed to beat the market, or in other words, a broad-market ETF.
So, if you were to become a passive investor through a mutual fund, you would be charged annually to have someone else manage your funds for you, usually at a much higher rate than most ETFs. Moreover, your mutual fund would likely never be able to outperform a market-following ETF in the long-term.
Therefore, in terms of passive investing, ETFs are generally the way to go. You should therefore just put your money into an S&P 500 index fund, which is a collection of the 500 largest and most established companies in the U.S., and 95% of the time you're going to make better returns than if you were to stick with a mutual fund.
One popular ETF that I wouldn't hesitate recommending is the Vanguard S&P 500 ETF (VOO). When comparing this Vanguard to the S&P 500 index, which you should aim to beat each year as an investor, VOO, at the very least, is able to match with the S&P 500. You can analyze the performance of VOO more in detail and compare it to the S&P 500 Index on Vanguard itself.
Passive Investing Struggles
While a passive investing strategy may be as simple as putting all of your investment-allocated money into an ETF, it really isn't as easy and stress-free as it may seem.
Here are some of the challenges you will likely encounter with this strategy:
- You need to make weekly/monthly contributions to do your "dollar-cost averaging." Maybe you're good at remembering to do this, but maybe you're not.
- You need to re-balance your portfolio when your allocations are out-of-balance from the volatility of these investments and price movements.
- You need to determine how to sell in a tax efficient manner.
- You need to change your allocations as you age (i.e., move towards fixed income as you age).
These four things, in particular, are what you should keep in mind as you continue to invest more money into your ETFs overtime. Fortunately, many investment brokerages nowadays help automate these not-so-fun situations.
Strategy #2: Dividend Investing
Dividend investing is a strategy that focuses on producing cash flow for the investor. This is done by purchasing companies on the stock market that pay dividends, as many publicly-traded companies do not issue dividends to their shareholders. These dividends are essentially small dollar amounts that typically larger and more established companies payout on a quarterly or monthly basis, as a result of you holding the stock.
The reason larger and more established companies are largely dividend-players, is because they may not have as much room for growth as smaller companies. So, once companies notice that they are well-established and are not growing as fast as they previously once did, this is when they may look towards paying dividends to keep shareholders around and reward them for investing.
Companies have absolutely no obligation to pay out or grow their dividends overtime and can cut their dividend whenever they choose. The best dividend-paying companies, however, will continue to grow and payout dividends as their income continues to grow. Regardless, because dividends are not guaranteed, dividend investors are not just looking for high-yield dividend stocks but safe dividend stocks as well. There is a fair amount of analysis that goes into figuring out whether these dividend-paying companies are safe and how safe they are.
The more that you invest in dividend-paying companies, the more dividends you will receive. Many dividend investors also reinvest the dividends they receive to take full advantage of the compound interest effect.
Dividend Stock Examples
AT&T (T) is a popular dividend stock that has virtually offered no growth over the 5-year period:
AT&T offers a 8%+ dividend yield (currently), which is the primary return shareholders have been receiving over these past few years. This is a pure income play stock here, as AT&T's stock price appreciation has not really grown over time, due to a number of reasons. Therefore, all AT&T really has to offer here for its investors is a high and steadily increasing dividend yield.
You can, however, also do a blended approach where you are investing for dividends and the capital appreciation of the stock price. This is the strategy dividend growth investors like to follow as well.
McDonald's Corporation (MCD) has a slightly low but decent dividend yield, and is a company that many people love because it actually has some growth potential, with a long history of paying out dividends to its shareholders.
MCD pays a dividend yield between 2-3% (currently) and have been paying out dividends for 44 years consistently. In addition, MCD has experienced capital appreciation over the last five years, at the very least. So, if you were to invest in MCD, you'd likely speculate for some capital appreciation and an almost guaranteed dividend payment every year.
Dividend Investing Struggles
Along with passive investing strategies, dividend investing faces its own set of struggles for the average investor, as described below.
1. Finding attractive dividend-paying companies
Dividends are never guaranteed as companies are not required to pay them out to investors. However, through proper analysis of a dividend-paying company, you can be quite confident as to whether a company will payout dividends for a long time to come. Even when you identify an attractive dividend-paying company to invest in, you'll also want to buy-in at the best price, which is a challenge on its own.
2. Using a brokerage that offers fractional share investing and/or DRIPs
To understand fractional share investing and dividend reinvestment plans (DRIPs), I will use a simple example. Let's say you own a stock that is trading at $50 per share. Let's also say that you receive $55 in dividend income from this stock every year because you own a lot of this company.
Well, if this brokerage doesn't offer fractional share investing, you're going to be able to buy one additional share of that stock, but that additional $5 is going to go into your cash account and just sit there, not letting you earn more in returns. So, you should choose the right brokerage that offers a DRIP or fractional share investing, just to ensure more of your money is invested into the stock market. Although this is still a struggle for dividend investors, this is becoming less of a challenge as investment brokerages become more sophisticated.
3. Experiencing a dividend cut
This is something that you never want to experience as a dividend investor, but it may be essential to the company to ensure its sustainability long-term.
If a company's fundamental business model no longer works and it begins dying out, or even if some very bad news occurred to their company, you should expect a dividend cut. There are also several indications you can look at if you happen to have invested in a dividend-paying company and want to confirm the chances of its dividend being cut.
Personally, if a company cuts its dividend, I would typically be very concerned and may choose to sell my investment completely.
Strategy #3: Growth Stock Picker
A stock picker focuses on picking individual stocks, primarily growth stocks, and speculating that they will increase in price over time and return a realized profit.
As a stock picker, you're essentially picking a small handful of stocks and attempting to beat the market at a much higher rate than just putting your money into something passive and more safe, such as an index fund. This, of course, is rather difficult to do and even the best investors fail to beat the market.
This strategy primarily involves fundamental analysis, which is reading and interpreting important financial documents, using valuation methods, and more, to uncover potential value. This type of investor also needs to have a higher risk tolerance, as individual "growth stocks" are more volatile.
So, if you're a beginner to the stock market, or would like to take a safer path to grow your investment, I would recommend staying away from being a growth stock picker investor.
Stock Picker Struggles
It's difficult to find inefficiencies in the market on a consistent basis. It was much easier decades ago when there were not millions of people on the stock market. With more and more people increasingly having the means to invest in the stock market, this is no longer the case and inefficiencies in the market get priced in almost automatically.
Again, this type of investing is also high stress. It should only be for individuals with a higher risk tolerance, which is not most people.
Other stock picker struggles include finding a platform that has the research tools you're looking for and learning how to conduct fundamental stock analysis. This in itself could require an entire website (like StableBread) or course. Lastly, as a stock picker, you have to thoroughly understand how to interpret financial documents and ratios, among other measures to be successful.
Strategy #4 and #5: Active Trader and Day Trader
Active traders trade in and out of stocks and capitalize on small price changes. This investment strategy comes with a lot of technical stock analysis, which includes charts, and is largely based on market sentiment or the general emotions of the market.
While a passive investor, dividend investor, and growth stock picker may hold stocks for months or years, an active trader is looking to hold stocks for a much shorter duration of time. In most cases, these are 2-5 day holds. For day traders, however, this may only be a few seconds or minutes, depending on the trade.
As mentioned before, active traders and day traders rely almost completely on technical analysis or the charts. They are not reading earnings reports or financial statements. In particular, these traders are looking at candlestick charts and make their profits through price and volume movements in highly liquid markets.
Traders also look for certain indicators and patterns and aim to capitalize on these micro-moves. These traders look for many small returns and attempt to cut their losses short, as the stocks they invest in are typically more volatile than others.
This is a high-risk form of trading and most are unsuccessful. This is purely based on statistics as 1% of day traders are predicted to be actually profitable.
So, if you had 100 day traders in a room, 90 of them would lose money, 9 of them would break about even, and only one would actually make money over the long-term.
The odds are definitely against you when it comes to being a day trader. This does not mean that this strategy is not worth pursuing, but it will require lots of dedication and time on your part to learn how to trade effectively, while ensuring long-term profitability over time.
Moreover, you need to be 100% emotionless when trading. It's when you get your emotions involved that you make bad decisions. Often times, greed turns winners into losers, and this is what you should keep in mind regardless of the investment strategies you choose to utilize.
The Bottom Line
The stock market investment strategies you choose to follow will depend on your investment goals and risk-tolerance levels. However, 99% of investors should buy a market-following index fund or ETF, as this is the hard-to-beat benchmark for which all other investments are compared to. The 1% of investors that choose to do active and/or day trading must commit a lot more time and practice in order to generate consistent annual returns that beat the market, while factoring in the significantly diminished net returns from short-term U.S. capital gains tax.