This Simple Idea Could Change the Way You Invest Forever

Feb 19, 2021

Last week, I sat down for an interview with a popular newscaster from Florida named Rachel.

She had heard about our work in bringing hedge-fund-level investing techniques to everyday investors (people like you and me).

Rachel even quizzed me about the “WallStreetBets” crowd that pushed shares of GameStop (GME) to sky-high prices last month.

After we finished the interview, we had lunch together. I found out what it’s like to raise four kids and have to be at the news station every day at 2:30 a.m.

(For the record, I don’t envy her at all… I could never do that!)

She also shared how impressed she was with TradeSmith’s mission to give “Main Street” investors access to the kind of powerful investment ideas, tools, and techniques that are typically only available to big Wall Street institutions and the wealthiest individual investors.

To be honest, I don’t always know the impact of our work. So, it felt great to hear this incredibly positive feedback from someone who doesn’t work in the industry.

It also inspired me to share one of these “secrets” of Wall Street investors with you here today.

But first, I’d like you to take a moment to answer a question for me:

How do you choose which stocks to invest in?

Now, don’t feel bad if you struggled to come up with a good answer. You’re far from alone.

The unfortunate reality is most individual investors don’t follow any kind of systematic approach when buying stocks.

They might buy one stock simply because they really like the company’s products… another because they read a compelling story about it in the news… and a third because a friend recently bragged about how much money they’ve made in it. The potential list is endless.

It’s not impossible to make money investing this way. But the odds are certainly not in your favor.

To be clear, I’m not saying you shouldn’t invest in companies you love or that have been recommended by friends.

I’m simply saying you shouldn’t base your decision on these criteria alone.

This is where factor-based investing — or “factor investing” for short — can be a huge help. In fact, I’m willing to bet that once you understand this idea, you’ll never think about buying stocks the same way again.

Let me explain…

If you’re not familiar, factors are simply the various characteristics of an investment responsible for its potential risk and reward.

You can think of them as the “reasons why” a particular investment does or doesn’t perform well.

Just about anything can be a factor. This includes everything from what industry a company operates in… to the nominal price of its shares… to how popular it is with investors, just to name a few.

However, research has identified a relatively small number of factors — less than 20 — that are highly predictive of how well a stock is likely to perform.

Some of these factors may be more or less useful depending on an investor’s risk tolerance or investment style, the overall market environment, and more.

But we here at TradeSmith have found there are five in particular that can be incredibly useful for helping individual investors beat the markets.

These are value, size, volatility, dividend yield, and momentum.

We’ll start with the value factor. This one is pretty straightforward…

Stocks categorized as “value” are relatively inexpensive, based on one or more of several common valuation measures like price-to-earnings (P/E), price-to-sales (P/S), price-to-free cash flow (P/FCF), or enterprise value-to-earnings before interest, taxation, depreciation, and amortization (EV/EBITDA).

Now, it’s important to understand that a stock can be undervalued for a good reason. But the data is clear… All things being equal, inexpensive stocks tend to outperform expensive stocks over time.

The reason should be obvious. Over the long run, we’d expect the market to value a stock based on its intrinsic value. This means undervalued stocks are likely to rise, while overvalued stocks are likely to fall.

Next up is size.

Size refers to the market capitalization — or “market cap” — of a stock.

This is simply the total market value of a company calculated by multiplying the total number of a company’s outstanding shares by the current market price of its stock.

In this case, low size or “small cap” companies — generally those valued at between $300 million and $2 billion — tend to outperform larger companies.

Again, this is rather intuitive. All things equal, large companies simply can’t grow their businesses as fast as smaller companies. Smaller companies are also more likely to fly “under the radar” of big Wall Street banks. And this lack of attention may make them more affordable at times.

The third factor is volatility… or more specifically low volatility.

This one may surprise you. After all, taking more risk is often equated with earning potentially higher returns.

But the data actually show the opposite is true here.

Over the long run, stocks with low volatility — meaning those that are more stable and less likely to experience wild price swings — tend to beat stocks with higher volatility.

It’s really a case of “slow and steady wins the race.”

It’s also worth mentioning that owning these kinds of “boring” stocks can also allow you to sleep well at night no matter what’s going on in the overall market.

Next is dividend yield.

Again, this one is pretty straightforward.

Stocks that pay dividends — particularly sustainable and growing dividends — tend to outperform both the market and non-dividend-paying stocks over the long term.

Last, but not least, is momentum.

Momentum is arguably the most important factor there is. I like to call it the “king of the factors.”

In short, stocks with strong recent performance tend to dramatically outperform those with weak recent performance.

In other words, stocks that have been rising tend to keep rising… while stocks that have been falling tend to keep falling.

If you remember nothing else I’ve written today, please remember this:

Momentum has historically been the single strongest predictor of future performance.

No matter what else you do in your investing, you’ll generally do much better if you invest primarily in stocks with positive upward momentum… and avoid stocks with downward momentum.

It’s such a simple idea… but it can literally transform your investment results.

Of course, there’s no reason you need to use just one factor in your investing. The real magic happens when you combine multiple factors.

This is what many of the world’s most successful investors do in their own portfolios. And it’s also the basis for our powerful Ideas by TradeSmith strategies (also included in our Trade360 package).

But you don’t need to be a TradeSmith subscriber to benefit from these ideas. And next week, I’ll detail the right way to combine factors to accelerate your gains, even if you don’t use our tools.