There's nothing wrong with accepting average stock market returns. If you invested $5,000 a year, earning fairly typical average returns of 10% a year, you'd have about $1.35 million at the end of 35 years.
But what if you don't want to be average? Try these seven surefire strategies for beating the average investor.
1. Automatically invest when the market drops
Average investors don't lock in mega-cheap prices when the stock market crashes. That's because they don't plan ahead. It's tough to make decisions when the market just tanked and you're in a panic. Plus, if you're not thinking strategically, you may not have extra cash set aside to invest.
Commit to automatically investing a certain amount when the market drops by a certain amount. For example, provided you're in good financial shape (meaning you're up to date on bills, you have emergency savings, and your debt is manageable), you could decide that for every 300-point drop in the S&P 500 index, you'll invest $1,000 more.
You may not beat the average investor if you're thinking about performance in the next month or year. The market may drop even more before it recovers. But if you're focused on being better than average over 10 to 20 years, taking the brainwork out of investing after a drop is a winning strategy.
2. Make index funds your backbone
Before you try to beat the market, make sure you've set yourself up to keep pace with it. The best way to do that is to start with low-cost index funds that invest across the stock market. Look for funds with an expense ratio of 0.1% or lower. The instant diversification gives you breathing room to focus on picking winning stocks.
3. Add individual stocks where you have expertise
For your stock selections, focus on areas where you have some knowledge. That doesn't mean you have to be an expert on software development to invest in Apple (AAPL 2.32%) or Microsoft (MSFT 1.29%). But you should at least have some basic understanding of the business, how it makes money, and its competitive advantage. You'll be light-years ahead of the average investor, who's picking the same stocks as the rest of the world based on the big news of the day.
4. Invest in small-cap stocks
Finding good small-cap stocks in the industries you understand well can have a huge payoff for your portfolio. You're investing in a company while it's young, before all those average investors find out about it. Some signs of a solid small-cap stock include:
- Steadily increasing revenue, even if it's not yet profitable.
- A strong competitive advantage.
- Customers who are passionate about the product.
Small-cap stocks do have above-average risks, though. If you'd rather spread out that risk, try investing in a fund that tracks the Russell 2000 index, which invests in the 1,001th to 3,000th largest U.S. stocks by market capitalization, or a small-cap index.
5. Don't ignore value stocks
Growth stocks get most of the headlines, but value stocks can be millionaire-makers as well. Case in point: Value investing, which is about finding stocks the market has undervalued, was the original strategy of legendary Berkshire Hathaway chairman Warren Buffett.
There's no exact science to spotting value stocks. Three metrics that are useful are the price-to-earnings ratio, the PEG ratio, and the price-to-book ratio -- though these metrics are only helpful when you're comparing similar stocks in the same industry.
6. Be an infrequent trader
Frequent traders may make a quick buck from the day-to-day volatility of the stock market. But price fluctuations aren't wealth builders. To create a winning portfolio, focus on buying stocks you believe you'll want to hold a decade or more from now.
7. Write down why you're investing in every stock
Make sure you have a good reason for investing in any given stock by writing down your case for it. Revisit your argument when you review your portfolio's performance. No matter how strong your logic, you'll still have some losers. But when you look at your underperformers, think about whether you stand by your reasoning and whether there are lessons you can apply to future investments.
Even the best investors make mistakes. But average investors fail to learn from them.