One of the fundamental building blocks of an investment portfolio, without a doubt, is stocks, particularly the stocks of U.S. corporations.
Research has show that stocks offer a long-term hedge against inflation that’s hard to replicate in other investments. Stocks offer a far more liquid form of investment, in that you can easily buy and sell them. Demand is steady and long-term.
And stocks provide income in the form of dividend payments. Not all U.S. stocks offer a dividend, but across the major indexes you can expect a 2% to 3% return just from dividends. As a result, stocks can match inflation over the long term while offering the potential upside of appreciation.
Yes, stocks also lose value. But you are not required to sell them when they decline. In fact, you should do the opposite, that is, buy more as prices fall. Rebalancing in a well-designed portfolio helps you automate this process, which can be difficult to perform consistently.
But how to invest in U.S. stocks? There a few schools of thought here:
1. Fundamental investing
Also called “stock picking,” the fundamental investor tries to measure the relative value of each company he or she might buy, looking for situations in which the rest of the market (or at least a large portion of it) has misunderstood the firm’s prospects.
Generally, other investors reward growth in the form or rising earnings. They buy more and share prices rise. However, when earnings slow or reverse there can be a sell-off, sometimes a quick one. It’s not easy work, but a small number of investors have become household names for doing well at this form of stock investing.
2. Value investing
A variant of the stock picker, the value investor is simply stalking the mall and waiting for a huge sale. He or she knows the companies well and spends more time analyzing far more firms than a stock picker. The fundamental investor probably will own 10 or 15 stocks at a go; the value investor must be ready to pull the trigger on any one of hundreds.
If a perfectly well-run firm that makes money falls 40% in price overnight, you pounce. Then it’s a waiting game as the market (one hopes) comes to realize its mispricing error.
3. Small-cap focus
One way to game stock-picking is to favor young, unproven companies, known as small caps. The risks are higher. In any given list of 10 new companies, eight maybe duds and the ninth a laggard. Yet the enormous potential of that tenth stock can help the small-cap investor outperform his peers over time, as research has shown.
So, which style of stock investing makes the most sense? For the retirement investor, all of them. By owning exchange-traded funds (ETFs) that capture the major indexes, you own the whole market. You get the dividend income but also the hot growth issues, the mispriced value stocks, the small-cap burners and, yes, the laggards as well.
You buy the index because research has also shown that stock pickers fail, repeatedly, to beat the market itself. Some do, yes, but most don’t and many fall short by horribly wide margins. They are prone to emotional trades, getting in too early and out too late, all the while piling up unrecoverable losses.
The ETF investor, however, can build a perfectly good portfolio that owns slices of indexes, amping up risk in precise measures and taking advantage of the pitch and roll of the markets to rebalance and cash out timely gains without all the dread that comes from active, full-time trading.