Investing in stocks is one of the best ways for most people to grow wealth. There are a number of ways to do it, though many strategies don't work as well as others. However, not having any strategy, and simply reacting to the market's ups and downs, is a surefire way to hurt your returns.
We asked three of our top contributors to chime in on this important topic, and they gave us three simple strategies that anyone can use. While these aren't "get rich quick" schemes -- which only line the pockets of those selling the scheme -- they are proven long-term methods that can boost your returns significantly over years of investing.
Dan Caplinger: One of the most often-used ways that people get rich in investing is by regularly putting money to work in their favorite investments. One way to do this is through a strategy called dollar-cost averaging.
Dollar-cost averaging couldn't be simpler. All you have to do is invest a fixed amount of money in a stock or fund at regular intervals. The benefit of the strategy is that it takes advantage of price declines in the stock, as your fixed dollar amount will buy more shares when they cost less. Over time, if a stock moves up and down but generally climbs in the long run, you'll often get better returns by dollar-cost averaging than you would by buying the same number of shares each time.
The biggest danger from dollar-cost averaging comes if a stock does poorly in the long run. Yet even in those cases, a dollar-cost averaging strategy might result in smaller losses than the more emotionally driven responses that falling stocks often bring out in investors. The discipline of dollar-cost averaging is one of its best features and a key component of its overall success.
Given the ease of making regular automatic contributions to investment accounts, it has never been easier to use dollar-cost averaging. The strategy is definitely worth considering if you know your chosen investments have good long-term prospects.
Jason Hall: If you're also looking to buy stocks that pay a dividend, there is significant evidence that you're on the right track if you focus on companies with this trait: regular dividend growth. A common mistake investors make is chasing the biggest yield, or percentage of the stock price that is paid in dividends, and not focusing on the quality of the business. Oftentimes those big yields aren't sustainable, which means the payout could get cut, leading to the double-whammy of the stock price falling.
On the flip side, companies with a history of regular dividend increases are far more likely to be higher-quality businesses, particularly if they maintain a larger margin of safety in their payout ratio, meaning they pay a smaller percentage of earnings in dividends. These companies are far more likely to weather the hard times while continuing to pay -- and increase -- the dividend, as well as investing in growing and strengthening the business.
The result for shareholders: long-term growth in both income paid and share price appreciation. Don't chase big yields -- focus instead on superior businesses that will pay you more each year.
Selena Maranjian: A great way to grow your wealth in the stock market is to do what Warren Buffett and many other great investors have done: seek undervalued stocks and thereby secure a margin of safety. This involves getting an idea of what a stock is intrinsically worth, and buying when it is trading for considerably less than that. The difference is the margin of safety.
It's tempting to chase high-flying stocks, but many of those have gotten ahead of themselves, price-wise. A company might indeed be headed for great heights over many years, but if its stock is temporarily overvalued, there's a decent chance it will fall in the near term. The stock price of an undervalued company is likely to rise, approaching its intrinsic value.
As respected investing thinker Seth Klarman noted, "A margin of safety is necessary because valuation is an imprecise art, the future is unpredictable, and investors are human and do make mistakes."
So how do you find such stocks, or determine that a stock is undervalued? Well, as Klarman noted, you'll never be entirely precise, but you might start with the price-to-earnings, or P/E, ratio. At Morningstar.com, for example, you can look up a stock's valuation and compare its recent P/E to its five-year average P/E. If it's considerably lower, then the company might be undervalued. At many sites, such as Fool.com, you can screen thousands of companies to find low P/E ratios and other appealing traits.
Research any company beyond just a few numbers, though, to make sure it's healthy and growing and has sustainable competitive advantages such as brand strength, economies of scale, or a strong network. Look for robust and, ideally, growing profit margins. Favor substantial free cash flow, too. Once you find promising, growing, seemingly undervalued gems, buy and hang on for the long term, as long as the companies remain promising.
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