New waves of get rich quick schemes have taken the public by storm recently, with the cryptocurrency gold rush and “meme stock” fever capturing headlines. For all the fervor around Bitcoin, Ether, and Dogecoin, we’ve seen that things in these young markets can get disrupted quickly — cryptocurrencies lost more than $1.2 trillion in value this month.
Meanwhile, plenty of people have also lost money by trading GameStop (NYSE:GME) and other highly volatile stocks whose prices were being pushed around by social media buzz and short squeezes.
It might sound a bit boring, but a long-term stock investing strategy that’s based on fundamentals can be a more reliable way to build wealth. If you follow a few time-tested guidelines, you can give yourself a great chance to beat the market without taking on too much risk. Here are three that you should start with.
1. Focus on fundamentals
All sorts of things can influence stock prices in the short term. Right now, for example, the market is reacting somewhat energetically to any hint of news regarding inflation, rising interest rates, increased regulation, tax policy changes, or new surges in coronavirus cases. And we all saw the strange trading patterns that hit meme stocks earlier this year, with their prices swinging wildly even when there were no real changes in their underlying businesses or financial prospects to justify those moves.
Weird things can happen to stocks in the short term, but over the long term, investors can expect stock prices to reflect the real financial returns of the business. Companies produce cash flows that are either invested in promoting further growth, stockpiled to improve financial health, or distributed to shareholders as dividends. Stock ownership ultimately entitles shareholders to a piece of the company’s profits, and investors should be willing to pay a certain price for the rights to those returns.
If you identify stocks that are performing exceptionally well now (or that will perform well in the future), then at some point, the share price should rise to reflect that performance. Investors can use a variety of metrics to analyze a company’s growth, financial health, operating efficiency, and valuation. These will tell you if its stock has good fundamentals.
2. Think about winners in the future economy
If you want to beat the market, then a good place to start is by seeking out companies that are well-positioned to become significantly more valuable than they are today. One useful technique that can help you pick those potential winners is to try to imagine what the economy will look like in five to 10 years, and in particular, what big changes are likely to occur over that time — the “global megatrends.”
For example, we can predict with some certainty that cybersecurity, robotics, artificial intelligence, data analytics, cloud computing, and fintech will become even more prevalent in the coming years. Some of the up-and-coming companies that are spurring change in those spaces are bound to grow. Some of the current leaders will also likely turn into giants, in the same way that Amazon (NASDAQ:AMZN) and Alphabet (NASDAQ:GOOGL) did by capitalizing on earlier megatrend waves.
3. Diversify your portfolio
Diversification involves getting exposure to a large number of different stocks, but what “large” means in this context will vary depending on who you ask. It could mean owning a few dozen different stocks, or a few hundred, or buying mutual funds and exchange-traded funds that give you exposure to thousands.
Regardless of how you measure it, diversification is a popular investment strategy because it dilutes risk and limits the damage that bad picks can do to your portfolio. However, diversifying also means that you’ll hold smaller stakes in your high-conviction winners, which will constrict your gains.
How much you diversify is up to you, but consider the limits of your own knowledge. By putting too much of your portfolio into just a few companies, you’re exposing yourself to anything unexpected that could drag them down. Remember, there were times when Blockbuster and Yahoo! both looked unassailable.
You can reduce your risks by investing in several companies within industries that are likely to deliver above-average growth, such as those involved in the global megatrends referenced above. You can even load up a bit more on your favorite companies within those spaces. However, spreading out your investments so that you’re betting on an entire industry is a lot less risky than guessing about the future of an individual company within it. And keeping your investments allocated across several niche categories will also keep you from just replicating the general performance of the market.
Investors who are able to tie all of these steps together will give themselves a great chance to enjoy returns well above the market average without taking on outrageous risk. That’s where a careful long-term strategy beats the kind of “investing” that’s more like gambling. You might not “get rich quick,” but you’re far less likely to get poor quick, too.
This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.