First of all, it’s important to understand that there is no guaranteed method or formula for picking successful stocks. With so many stocks available, there are even more ways investors approach the market, including various philosophies, schemes, strategies, and mindsets.
If you’re new to investing or if you want to rethink your investment strategy, it’s important to remember these seven important principles before choosing stocks:
1. Believe in yourself: Remember that investing involves taking risks, and you’re essentially betting on your own decisions.
2. Set clear goals: Determine what you want to achieve with your investments, whether it’s long-term growth, income, or something else.
3. Stick to what you know: Avoid investing in businesses or industries that you don’t understand well, as it can be difficult to assess their potential for success.
4. Learn about financial ratios: Understanding financial ratios can help you evaluate a company’s financial health and make more informed investment choices.
5. Be wary of “too good to be true” opportunities: If an investment sounds too amazing or promises unbelievable returns, it’s important to be cautious and do thorough research before jumping in.
6. Assess the “moat”: Consider the competitive advantage or barriers to entry that a company has, as this can play a role in its long-term success.
7. Understand systematic risk: Recognize that all investments carry some level of risk due to broader economic factors or market trends, and be prepared to manage and mitigate those risks.
1. Believe in yourself:
Before you jump into the stock market with dreams of becoming the next Warren Buffett, it’s crucial to understand the game you’re playing and the odds stacked against you.
When you pick individual stocks, you’re essentially trying to outperform the overall stock market and achieve better returns. However, this is extremely challenging. In fact, studies have shown that 88% of professional fund managers fail to beat the market after five years, and nearly 94% fail after 15 years.
Individual investors face even greater challenges. Unlike professional managers, they don’t have the luxury of dedicating their entire lives to studying investments. Everyday investors often make mistakes driven by emotions, such as buying stocks when they’re doing well and selling when they’re down. Overtrading is another common pitfall. These psychological mishaps contribute to the poor returns experienced by many individual investors.
While this principle may not be the most satisfying to hear, it is the most important one. By choosing to pick stocks instead of investing in a low-cost index fund like the Vanguard 500 Index Fund, which automatically earns you market returns, you’re taking on a bit of arrogance and going against the odds.
2. Set clear goals:
If you still want to choose your own stocks, despite the challenges, the next step is to define your goals. Are you a young investor looking for high-risk, high-reward opportunities to build a large stock portfolio by the time you’re 40? In that case, you should focus on growth stocks or contrarian options that have the potential for big gains.
If your timeline is shorter and you prefer a safer approach with some income generation, consider blue-chip companies and dividend stocks. Real estate investment trusts or dividend aristocrats could be good choices for your portfolio.
If you’re interested in short-term momentum trading or chart-based strategies, those fall outside the scope of this discussion.
Ultimately, having a general idea of your investing goals will help you narrow down the vast selection of 8,000 stocks to the ones that align with your portfolio.
Consider your personal risk tolerance as well. If you’re uncomfortable with the idea of losing money, even temporarily, it’s best to stick with less risky options, even if your goal is to retire by 40.
Remember, it’s not beneficial to panic and pull out of the market at the first sign of trouble. Stay the course and remain invested. History has shown that the market has always recovered from downturns.
3. Stick to what you know:
A stock is like owning a part of a business. Imagine if you were going to invest in a small local business. Would you give your money to that business without checking its financial records and understanding how it makes money, spends money, its seasonal patterns, opportunities, risks, competition, and advantages?
Most likely not.
To choose good stocks, you need to do the same careful research and understanding. Many successful investors have emphasized this point over time. Warren Buffett has been saying this for decades, and Peter Lynch, a well-known former fund manager, advised not to invest in something you can’t explain simply.
Each company has its own strengths and risks. For example, big multinational companies with established supply chains and a presence in the global market usually have less risk compared to startups or companies going public for the first time (IPOs). The bigger companies are more capable of dealing with market difficulties, according to Dan Cronin, the founder of Lifestyle Wealth Management in Hawaii.
However, the downside is that large companies have limited potential for growth, whereas a small IPO could double in size before you retire.
“If you do choose specific stocks, try to learn as much as you can about them and be confident in their story, financial situation, and future plans,” says Cronin. “This will help you stay invested even when their stock prices drop.”
And keep in mind that every company, no matter how good it is, will experience both successful and challenging periods.
4. Learn about financial ratios:
Once you have determined your goals and found a business that you understand and like, the search doesn’t stop there. You also need to figure out if the stock you’re considering is cheap or expensive.
This is where financial ratios come in handy. These ratios are calculated using information from the stock’s market value, as well as numbers from the balance sheet, income statement, and cash flow statement. Some well-known examples of these ratios are price-earnings, price-sales, and price-book. They help you understand how the company’s stock is valued compared to its financial performance.
These ratios can give you insights into how well a company can pay its debts, how profitable its operations are, and how efficient it is. You don’t have to analyze every single financial ratio before investing, but it’s important to know where the important ones stand compared to similar companies and also understand the direction in which they are moving.
5. Be wary of “too good to be true” opportunities:
If something seems too good to be true, it probably is. This old saying is still relevant in the stock market, where there are many misleading temptations for investors. One common mistake that new investors can make is being attracted to stocks with seemingly attractive valuation metrics, especially the price-earnings ratio (P/E ratio).
Certain types of companies, like homebuilders, automakers, and banks, may sometimes have P/E ratios much lower than the rest of the market, which can make them appear cheap. However, just because you see companies with single-digit P/E ratios doesn’t mean those stocks are undervalued. In fact, the market might be indicating that the peak of their earnings cycle is over, and their past earnings are higher than what can be expected in the future. These seemingly cheap stocks are called “value traps.”
Another temptation that many investors face is the desire for high dividend yields. While a good blue-chip stock may pay a dividend of 2% to 4%, there are plenty of stocks in the market that offer yields of 7% or even higher.
However, extremely high dividend yields are usually a warning sign. It could mean that the stock has experienced a significant decline for a valid reason, or it could suggest that the previous dividend payments are unsustainable and likely to be reduced or stopped altogether.
6. Assess the “moat”:
If you want to create a portfolio that you can set and forget, it’s important to choose stocks from companies that have long-term advantages that make them stand out from the rest. Warren Buffett calls these advantages “moats,” which act as protective barriers for the company.
Essentially, economic moats help companies not only survive but also thrive over time by protecting their profits. For example, Coca-Cola has a strong global brand and a wide distribution network, which gives it an advantage over competitors. Similarly, Apple has a globally recognized brand, network effects that make their products more useful as more people use them, and high switching costs. Switching to a competitor would require users to adapt to new software and purchase new compatible accessories.
The strength of a company’s moat affects how much investors are willing to pay for its stock. Wider moats are considered more valuable, so investors may be willing to pay a higher price for stocks of companies with stronger advantages.
7. Understand systematic risk:
The final thing to understand about picking stocks is that the performance of your portfolio will often go up and down due to reasons that have nothing to do with the specific stocks you own. Last year was a good example of this, as all three major U.S. stock market indexes experienced significant declines because of factors like inflation, war, and rising interest rates.
These external factors, which no single company or board of directors can control, can negatively impact even the best long-term stock choices. It’s impossible to completely eliminate this broader market risk, but investors can reduce company-specific risks by diversifying their investments.
Although systematic risk is unavoidable, investors can manage it by buying stocks that have a lower correlation to the overall market. These are known as low-beta stocks. On the other hand, investors can also choose high-beta stocks, which are more closely tied to market volatility. Beta is a measure of how much a stock’s price moves compared to the wider stock market, with 1 being the average.
While beta isn’t a perfect measure, in general, stocks with betas below 1 will have less dramatic price changes when the market goes up or down, while high-beta stocks will experience larger swings. In theory, low-beta stocks are considered more favorable during bear markets, while high-beta stocks are seen as better choices during bull markets.