Beginning investors are often happy to earn market-matching returns. But given the way the stock market has performed recently, you may have had enough of settling for big losses during down years.
In order to break out of that rut, you'll have to go beyond your comfort zone and start branching out into unfamiliar territory. You don't have to do it all at once, though. Just dipping your toes into new stocks that you've never looked at before will be enough to get you started on the road to better returns.
It's not all or nothing
One common debate among investors involves whether people should stick entirely with passive strategies like index investing or should strive to beat the market by actively managing their portfolios. Proponents of active investing point out that deciding just to match an index's return means suffering big losses during bear markets, such as the 37% loss in the S&P 500 during 2008.
On the other hand, index investing advocates note how hard it is to beat the benchmarks. The vast majority of actively managed mutual funds fall short. And even though many have pointed out some of the bad investing moves that index funds are forced to make, judging from the failures of many active investors, it's not necessarily as easy to exploit those mistakes as you might think.
Luckily, you don't have to pick one strategy or the other. By coming up with a prudent mix of both, you can both enjoy the benefits of index investing while also expanding your horizons to learn more about other investing strategies that could earn you market-beating returns over time.
Be a closet indexer
In mutual fund investing, one mistake many investors make is to buy shares of actively managed funds that don't stray too far from the benchmarks they're measured against. When you look at the top holdings of these funds, you'll see stocks like ExxonMobil
Known as closet indexing, this strategy doesn't benefit fund investors. They end up getting the worst of both worlds: They suffer the full ups and downs of index funds, but they also have to pay the higher fees associated with active management.
It doesn't make sense to pay up for what amounts to an index-style investment. But if you're the one doing the closet indexing, that's completely different.
For instance, say that you're interested in stocks that have enjoyed strong growth in the past but now look like attractive values. To find them, you run a screen that includes 15% minimum growth in both earnings per share and revenue over the past three years, as well as low debt-to-equity values and earnings multiples. Here are some of the companies that pop up:
|
Stock |
3-Year EPS Growth |
P/E Ratio |
Return on Equity |
|---|---|---|---|
|
Coach |
21.3% |
11.2 |
50.4% |
|
Marvel Entertainment |
47.7% |
11.4 |
51.8% |
|
Western Digital |
32.5% |
7.4 |
24.6% |
|
OptionsXpress |
24.6% |
11.0 |
33.7% |
|
Fluor |
48.9% |
9.6 |
27% |
Source: Motley Fool CAPS.
But since it's your first foray into stock picking, you're not entirely confident that your theory is valid. So, here's what you can do:
- Keep a large percentage of your money -- say 90% -- in index funds or other investments that you're already comfortable with.
- Take the remaining 10% and use it to experiment on ideas like the screen above.
This has an obvious tradeoff: You're not going to strike it rich with your own ideas, because you're not investing much of your money in them, but you're also not going to go broke if your strategy doesn't turn out well. By keeping your risk low, it's easier to view your performance objectively, learn from mistakes, and build on the things that you get right to incorporate them into new, better strategies.
Don't panic
Sure, you could probably reach most of your financial goals simply by saving enough money and earning market returns over time. But if you're interested in continuing to learn about finances, it's worth it to step up your investing to the next level. By taking baby steps, you'll get the experience you need without putting your life savings at risk.
For more on how to invest right now, read about:
- Five value traps you should avoid.
- How swine flu could affect your portfolio.
- Did you already miss the best day to buy?
