What's the right strategy for a newbie investor?

I recently wrote about a screen and a number of stocks that were making 52-week lows. One of the comments on the article series asked a thought-provoking question (reworded for clarity):

Should this type of investing (unhealthy companies and negative trending eps performance) be avoided by new investors?

I thought this was a topic worth exploring further.

Strategies we write about

First up, it's worth noting that we are unlikely to write about losing strategies on Stockopedia. We may write about the warning signs that tend to indicate poor investment outcomes, for example, my Gearing up to Fail article from a while back. However, we tend to avoid writing about shorting stocks (profiting from the share price going down) as this is a very advanced (and often risky) strategy. Hence, we tend not to screen for losers.

If we write about a strategy, in this case, 52-week lows, it is because it has some attractive qualities. Usually, the strategy is backed by academic studies showing outperformance against market averages. For 52-week lows, the seminal paper is one called Volume and Price Patterns Around a Stock's 52-Week Highs and Lows: Theory and Evidence, where Steven Huddart, Mark Lang, and Michelle Yetman found that buying a basket of stocks that hit 52-week lows outperformed the general market.

Of course, academic evidence alone doesn't guarantee outperformance. Sometimes the market adapts. For example, when Richard Sloan published their research into the accrual anomaly in 1996, the effect promptly stopped working. (The accrual anomaly found that stocks where cash flow more closely matched earnings outperformed those that didn't. The thesis was that investors focused too much on accounting earnings and not on cash generation.) It stopped working because, presumably, practitioners read the paper and adapted to focus more on cash flow and not just reported earnings. Momentum is the strongest-performing academic anomaly, yet funds created to exploit this have largely failed to outperform the market. It seems that the impact of costs, or other factors, may mean that a strategy fails to deliver in practice, at least when implemented in line with the academic research..

In addition, Stockopedia has tools that show how different strategies perform. For example, the Contrarian style of investing that most closely matches a 52-week low has a good track record of beating the market over the last 10 years:

There are also a number of Guru screens, based on the writings of successful investors, and these can make for interesting articles. The assumption is that by trying to replicate some of the ways of successful investors, we may see similar success.

While all of this is intended to give investors a chance of beating the market, it doesn't mean that all of these are suitable for newbies. Before I look into what these strategies might be, here's a sobering thought:

Expect to lose money!

It takes time to develop the skill of being a successful investor, even if success here can be well-defined. What makes investing such a fascinating pursuit is that we are competing against other knowledgeable and motivated individuals. Investing differs from gambling in that it isn't a zero-sum game (or negative if you exclude the role of a bookmaker), and we all benefit from the tendency for GDP to grow and be reflected in positive returns on equity. However, if investors want to beat the average market participant, i.e. beat the market, this is a difficult task over the long term, precisely because other investors tend to be intelligent and motivated. Being likewise isn't enough; investors need an edge. That is, the ability to know something others don't, analyse information more effectively, or behave more rationally than the average investor. While the Stockopedia tools can certainly help with the latter two of these, the reality is that newer investors probably won't have the skills to employ them effectively. They also won't have the experience to know what they don't know.

Looking back to my own formative years, when I first started to buy individual stocks, my investments included a prospective gold miner with a vast resource, which was popular with a well-known resource investor at the time, but the company operated in risky lands and had no financing in place. I have a First in Maths from a good university, so even as a newbie, the mathematical part of investing came naturally to me. For example, I easily created extensive discounted cash flow models of another resource company where I had invested based on the prodigious cash flow they were generating from a direct shipping operation. However, I failed to realise that when the commodity prices fell in response to the Great Financial Crisis, the company wouldn't just face reduced demand for their product, but no demand. Needless to say, I lost almost all my money in these first investments.

The good news is that investing is a marathon, not a sprint. It is the long-term consistency of results that matters when compounding wealth. I was in full-time employment at the time, so I could rebuild my capital, and I learnt from my mistakes: to be more sceptical with pre-revenue companies, to trust my own judgement not rely on others, and to understand the underlying economics of a business rather than rely wholly on the false precision of a model. Given that these mistakes are now around 20 years ago, having a long-term investment horizon means that the daily noise of price moves in my portfolio today dwarfs what I lost in those initial learning exercises.

Investors absolutely need to be prepared to lose money, or at least underperform the market, in those early few years as they develop their edge. They shouldn't be disheartened by losses but treat them as learning exercises. Indeed, perhaps he worst thing that can happen to a newer investor is a string of initial good investments. While this may sound great and a sign of success, it is equally likely to be due to luck or very strong market conditions. The problem is that when early wins become losses, the investor has already probably become overconfident (as we all tend to do), and the size of the eventual losses are much larger. With investing, it is better to fail early, as long as investors learn from the failures and keep going. This is also why investors who start with a large sum compared to their income, say from an inheritance, need to be especially wary – unless they are careful, the price of their lessons may be much higher than most.

Diversification as a learning opportunity

One of the other lessons I learnt early on was the importance of appropriate diversification, having been painfully under-diversified at times! For most investors, there is a trade-off between the costs of investing (broker fees, stamp duty, spreads, etc.) and the benefits of diversification. There is also the risk that those with a huge number of holdings simply track the market. I believe newer investors are better off holding more holdings, even if the amount they have in each is somewhat suboptimal compared to the trading costs and time to do detailed research. As well as limiting the negative impact of a single poor investment decision, more diversified newer investors are also gaining far more learning opportunities. Of course, Stockopedia allows subscribers to have multiple portfolios, and there is nothing wrong with using this feature to have paper portfolios. However, in my experience, nothing matches having actual money on the line for learning quickly.

Lean but don't rely wholly on the Stock Ranks

The Stock Ranks give investors a great way to assimilate many pieces of important investment information into some simple metrics. Given the long-term performance of the high Stock Rank shares, it may be tempting to be a quant investor and only buy Super Stocks. There are a few issues with this, including possible crowding in specific sectors or people businesses. (I looked into this in more detail here.) The biggest issue for a newbie is likely to be long periods of underperformance. The 5-year chart for the QVM Rank shows the usual picture:

High Stock Rank stocks perform well, low ones don't, on average. Looking in more detail, there is a considerable period where the top decile underperformed. Investors who were buoyed by the strong performance of the annually rebalanced superstock portfolio in early 2021 would see the strategy underperform for four years, only reaching new highs recently. It would also have underperformed the UK indices during most of this period (on a price basis). While experienced investors will know that this is what can happen even with known market-beating strategies, a newer investor may be put off by this and bail just as the strategy starts to perform again.

The other issue is that having a high Stock Rank doesn't preclude a company from issuing a big profits warning. Take IG Design (LON:IGR) , for example. The stock had a 99 Stock Rank in August 2024 and lost investors 75% of their money over the following six months:

This doesn't mean that the Stock Ranks don't work on average, just that the variation in performance of a single Super Stock is still very wide. The Stock Ranks are incredibly useful for new investors as they enable them to easily avoid the types of stocks most likely to be losers. However, buying into one or two of even the highest-rated Super Stocks isn't enough to guarantee success. The evidence points to Super Stocks outperforming on average, and over long periods of time.

Find your style

One of the implications of the original question was that buying stocks at 52-week lows would be psychologically challenging for newer investors. This is true. However, it is true because all winning styles are psychologically hard. Buying stocks that are hitting 52-week highs is also difficult for many investors, which is why this strategy is also a winner. Momentum investing is also tricky, as it requires the discipline to exit a winning stock after the share price has peaked. Newer investors who bought into Warpaint London (LON:W7L) during its phenomenal rise are probably still holding, as the share price has halved and the Momentum disappeared, as they lack the market experience of how these things tend to play out. Quality investing, holding good stocks for the long term, sounds easy, but spotting companies with a genuine moat and having the nerve to hold is genuinely difficult. Strangely, Quality Investing may be the style that least suits newer investors. This is because the skills of analysing a business, its true moat, and its ability to reinvest capital at high rates, are very hard to do for any extended period of time. Newer investors are unlikely to have developed these skills.

With almost all successful styles of investing psychologically hard to implement, the focus of the newer investor should probably be on finding the style that suits them best. The benefit of finding a style that works for them is that investors will be far more sanguine when the periods of underperformance occur. Over the last few years, my focus on smaller stocks, where I believe I can have an informational or analytical edge, has cost me performance, as larger UK companies have significantly outperformed. I've worked hard to generate index-like returns. However, my experience tells me that these conditions don't tend to last forever. The valuation gap between the larger companies and the small caps is now so large that it would be hard to envisage this situation continuing over the next five years. However, if it did, I would be relaxed about it, as I would be compounding large dividend payouts into stocks at ever lower valuations and higher yields. Eventually, this type of anomaly tends to correct itself, but I just don't know when it will. Less experienced investors may not be able to have this perspective.

Conclusion

I don't think any particular style of investing is more or less suitable for newer investors. When starting out, the key aims should be to gain as much knowledge and experience as quickly as possible. This is done by having a more diversified portfolio, even if it ends up suboptimal from a trading costs perspective. The increased learning opportunities are likely to outweigh the negative impact on performance. The Stock Ranks can certainly help newer investors, and if investors simply didn't invest in stocks with a low Stock Rank, they will almost certainly do better overall. However, the focus of newer investors should be on finding a strategy that is a good fit for their unique personality and circumstances. For some, like me, that may be a more contrarian approach. Others will find a more natural fit with Momentum or Quality styles, or a mix of these. Finding a good approach and sticking with it is likely to be the key to generating good investment results for decades to come.