The big discussion on Wall Street almost always seems to revolve around whether the broader market is headed higher or lower from where it is right now. However, sometimes it does neither and instead treads water.
Following the biggest recession we've seen in multiple generations, and also one of the biggest rallies, the broad-based S&P 500 (SNPINDEX:^GSPC) has essentially gone nowhere over the past year and a half. We've had temporary bouts of excitement with two quick market corrections during the summer of 2015 and during the first-half of the first quarter of 2016, but looking at things from a longer perspective shows that we're essentially in the same boat we were in near the start of 2015.
For some investors, a sideways stock market can be truly frustrating -- but it doesn't have to be. There are four strategies that you can simultaneously implement that can give you a really good chance of making money even in a sideways market.
1. Continue buying core portfolio stocks
First, keeping the really big picture in mind can help. Over the long term, the stock market tends to move higher. In fact, the stock market has historically returned an average of about 7% per year, including dividend reinvestment, making it one of the best creators of wealth available to the public. This means your best way to prepare for the future is to keep investing.
What happens if you choose to try and time the market, or wait for a so-called "breakout"? Chances are, you'll wind up missing out on some gains in the process. Missing out on a good day here and there may not sound like a big deal, but over the long run, it can really add up.
J.P. Morgan Asset Management, using data from Lipper, ran an experiment to see what would happen if an investor bought into the S&P 500 on Dec. 31, 1993 and held for the next 20 years without selling. By the end of this period the data showed that the investor would have made 483% on his or her initial investment. Mind you, this fictitious investor would have held through the dot-com bubble and the Great Recession and still come out higher by 483%. If, however, this investor missed just 10 of the best trading days over a 5,000-plus trading-day period, their return dipped to only 191%. Miss a little more than 30 of the best trading days and the investor would lose money overall. Trying to time the market and being wrong could cost you valuable time to compound your nest egg, and it could add years to how long it'll take to reach your retirement number.
2. Invest and reinvest in dividend stocks
Secondly, you should strongly consider investing in dividend-paying stocks.
There's nothing wrong with buying growth stocks, especially if you expect to be in the labor force for years or decades to come. However, it's never a bad idea to consider adding high-quality dividend stocks to your portfolio since they can provide both the income and stability needed to help weather periods of potentially subpar economic growth or stock market advances.
Two things, in particular, make dividend stocks a valuable target for investors in a sideways market. First, we have the natural advantages of dividend-paying companies:
- Dividend payments help hedge against downside in the stock market.
- Dividends can be reinvested in more shares of the stock to compound your future dividend payments.
- Dividends are often a sign of a healthy business model, and thus act as a beacon for investors to follow.
The second factor is that dividend stocks tend to outperform non-dividend paying companies over the long-term, more than likely for the reasons just described. Dividend-paying companies often have healthy business models and steady cash flow, which means they're well-suited to handle whatever comes next, be it a strengthening or contracting economy.
3. Consider a hedging strategy
Third, if you're worried about the potential for a stock market correction, even with the understanding that corrections last for shorter periods than bull market rallies, you can consider a hedging strategy to protect your portfolio. There are two particularly intriguing hedging strategies to consider.
First, if you feel comfortable using options, you can consider selling calls against some, or all, of your long-term buy-and-hold positions. A call is an option that investors buy when they expect a stock to increase in value. By selling a call, you'd in effect be expecting that the stock you own would move sideways or lower by the expiration date of the contract (most options contracts range from one week to two years in length). In easy-to-understand terms, if the share price of your stocks falls, you'd expect to collect a 100% profit on your sold calls. While this might not be equal to the unrealized losses you'd sustain from a stock market correction, it certainly could remove some of the sting. Just be aware that this hedge works the other way around, too. If the stock market heads into rally mode, your gains could be muted if your options hedge produces losses.
Another hedging idea would be to buy defensive stocks, ETFs, or commodities. For example, physical gold and precious metal miners are often viewed as good hedging bets. Gold prices tend to move in the opposite direction of the U.S. dollar, and the strength of the dollar tends to increase in step with the U.S. economy. If the U.S. economy begins to falter and the dollar drops, gold and precious metal miners benefit. Gold is, of course, not the only defensive idea on the table, but it's a pretty good example of using a hedging strategy to provide some downside protection.
4. Jettison stocks that no longer fit your investment thesis
Finally -- and this is something you should be doing all the time, regardless of whether the stock market is going up, down, or sideways -- analyze the stocks in your portfolio to determine whether or not your investment thesis for them still holds water.
Before we buy stocks, we should conduct a pretty rigorous analysis that allows us to summarize why we bought them in the first place. As investors, we should be reviewing this summary, or investment thesis, on a fairly regularly basis to see if it still holds true. If a stock drops on account of market weakness, but the underlying business model remains intact, then your investment thesis should still hold water. However, if the business model has changed due to a new competitor, product, or any number of X-factors, then it may be time to consider selling your position. Companies whose business models have changed or are in jeopardy are usually the most susceptible to declines during a sideways or downtrending market. Remember, crossing your fingers and hoping for the best isn't an effective investing strategy.
The tools to succeed in a sideways market are at the ready; it's just a matter of you being proactive and seizing these opportunities.