Investing in the stock market is one of the best ways to build wealth and become an active member of the economy.
Somebody (or many somebodies) has probably encouraged you to invest in the market at some point, but learning how to pick stocks can be intimidating if you don’t know where to start.
Today we will discuss the foundational components of investing in stocks, how to identify companies you want to invest in, and recommend some tools and tricks so you can learn how to pick stocks. Ready to get investing? Let’s dive in!
Why Invest in Stocks?
Stocks provide a tangible vehicle to participate in the financial performance of a company. If a company is publicly traded and listed on an exchange, you can purchase shares through a broker online or on the stock exchange.
When you invest in stocks, you gain access to a wealth-building tool and an income stream. Many people think that you make money in the stock market when the stock’s price jumps. While this is true, shareholders also receive rights to dividends, which can be a fantastic asset for income-oriented investors. Dividends are one way for companies to pay their investors out of their earnings. Finding stocks with a high dividend yield is important because dividend yield is an indicator that the company will pay good dividends regularly.
Depending on your financial goals and status, dividends have a two-fold advantage. If you have a long time before you retire or need access to the funds, you can elect to have your dividends automatically reinvested into more shares of the company. This is what creates compound returns; compounding returns are the secret to growing wealth with stocks because, over time, your stake in the company grows without you needing to purchase additional shares.
If you are close to retirement or are trying to build a passive income stream, you can choose to have the dividends deposited directly into your account. Many people rely on dividend income because it is generally consistent, and as long as you have a diversified portfolio, you have access to consistent income for years to come.
Stocks vs. Funds
Many people discuss stock market investment terminology such as mutual funds and stock shares interchangeably, but there is an important difference.
Mutual funds are groups of many different stocks bundled together, and the investor will purchase a share in the fund. One share in a fund may contain fractional pieces of hundreds of different companies, whereas one share of a publicly traded company only represents ownership in that one business.
For example, the S&P 500 Index is a group of the largest 500 market capitalization stocks on the stock market. If you purchase one share of an S&P 500 fund, you will probably not own 500 shares of stock, so, instead, you will own pieces of all 500 and that one mutual fund share.
If you purchase shares in ten or more companies within the S&P 500, you will own ten shares of 10 different companies.
There are pros and cons to purchasing single stocks versus investing in mutual fund shares. Ideally, you will invest in both and create a diversified portfolio.
Exchange traded funds are (ETFs) are a great way to pick stocks and invest in a diversified basket of companies simultaneously. When you invest in shares of an exchange-traded fund, you buy shares of a larger basket of stocks. If you like to trade stocks, but do not know which individual stocks to purchase, then these are an excellent way to have your cake and eat it too.
Trading ETFs enables you to filter stocks based on their industry or market segment. For example, if you like financial services, you buy shares of a financial industry ETF which gives you exposure to that market without taking on too much risk.
The Importance of Choosing the RIGHT Stocks
While investing in the stock market and purchasing shares is an amazing way to build wealth, it’s important to choose the right stocks to not lose your entire investment and enjoy future performance.
This is a critical component of investing, so please pay attention. There is no ultimate stock pick that is perfect for every investor. Some stocks in established firms that have lower volatility may not be ideal for a growth investor. At the same time, certain growth stocks might be too volatile for an investor looking for long-term value without the share price jumping around too much.
A couple of rules of thumb for making a solid investment are investing in what you know, which means buying shares in companies that you understand how their business model works, what products or services they sell, and they have publicly available easy to read investor presentations.
During your stock picking process, it’s generally best to avoid buying hyped-up stocks or low growth companies that are highly volatile and may crash or be part of a scam.
Choosing the Right Stocks for YOU
When you are looking for stocks to purchase and add to your portfolio, you must define what you were looking for and why you are choosing one sock over another. For instance, are you looking for stable blue chip companies with a competitive advantage, or are you trying to swing trade penny stocks?
Let’s dissect the different pieces choosing the best socks for you and your investment perspective.
What is your performance goal?
This is your why. Ask yourself what you are looking to get out of investing in stocks. A couple of examples could be generating income which means you would want to focus on dividend stocks, or building wealth through capital appreciation which may mean looking at growth stocks or value stocks.
Some examples of performance goals can be investing in companies with solid revenue growth, earnings growth, or emerging markets nations.
What is your time horizon?
Once you identify what you were looking for out of your stock Investments, map out how long you want to be invested to understand when you will buy and sell stocks.
If you are at the beginning of your career and have decades ahead of you, you will probably have a very different strategy than a pre-retiree who needs to ensure they have a strong financial foundation.
What is your investment strategy?
There are countless investment strategies when it comes to the stock market, but two of the most common are buy-and-hold strategies or active trading.
Buy-and-hold means that you are planning on owning the shares for a long time, and you are comfortable with ups and downs in the short term. Proponents of buy-and-hold generally are more follow Warren Buffett’s advice on value investing and look for stable blue chip corporations that are undervalued. If you are a more conservative investor, this may be a great stock picking strategy.
Active trading means you buy shares at a predetermined entry price with plans to sell the share after you achieve a certain return or loss threshold. Active day trading generally requires a more aggressive investor willing to dive deep into the financial news of a particular company for their stock picking. Swing trading is another form of active trading where investors are not interested in industry fundamentals, but are more interested in big market movements and capturing gains during periods of high volatility. However, swing trading is not for the faint of heart because it can be very risky for most investors.
Do you have any preferred sectors?
If you are in the medical field, you probably have a wealth of knowledge on how doctors’ offices work, pharmaceutical reps are compensated, Etc. Likewise, if you enjoy learning about the financial services industry, you may prefer to start looking at stocks in that investment space.
Identifying a sector that you are familiar with either as a consumer or a professional is a straightforward and rewarding way to learn more about the financial components and participate in that sector’s performance.
How to Pick Stocks
Once you’ve narrowed down your goals, strategy, and general approach, it’s time to start looking for stocks.
Step 1: Define What You Are Looking For (i.e., tech stocks in high-growth sectors)
Stock prices can vary wildly depending on what sector they are in and how established their business is.
Although each business is unique, there are some general categories you should be aware of depending on how comfortable you are with risk.
Risk is essentially the likelihood of loss – you may be familiar with the phrase “high risk means high rewards,” but there is an important caveat that is often ignored. The phrase should be “high risk has the potential for high rewards AND high losses.”
Along with other useful investment metrics, defining your risk parameters and time horizon will help you identify the types of stocks that fit your investing style.
Step 2: Find Your First Pool of Candidates
Thanks to online market news, company websites, books, and real-world case studies, there is an abundance of tools at your disposal to help identify stock candidates that could fit your criteria.
Use Stock Scanners
Stock scanners enable you to enter specified criteria for different stocks and the company’s earnings data. The scanner will alert you when all the stocks in your range reach your price goals.
You can search for stocks based on price, price movement, quarterly earnings, and more. Stock scanners can be fantastic resources for new and experienced investors alike because sorting through thousands of stocks all day can quickly become exhausting.
There are also thousands of stock research websites, like Motley Fool, Zacks Investment Research, and Morning Star. There are also blogs, professional analysts, and everything in between. Different articles will offer unique investment advice, and if you find a financial analyst you like, then consider subscribing to his or her market research platform.
Step 3: Research Individual Stocks and Narrow Down Your List
Dive deeper into companies to see who meets your criteria
There are plenty of additional checks you can perform to see if an investment meets your investment criteria. Some considerations to look out for include the below.
Considerations for Researching Stocks
There are many different aspects of what makes one company a better investment than another. Here are a few key metrics you can use during your research to help you make the most educated decision:
- Company Strength (Competitive Advantage) – How does the company perform against its competitors? Is it in a good position to stay in business and maintain a competitive edge?
- Company Management -Is the corporate leadership effective in delivering profitable results and maintaining a competitive edge?
- Financial Strength – Is the company able to pay its bills and meet its obligations while still investing in new technology and developments?
- Accounting Ratios – These are ratios such as the Debt to Equity ratio or Price to Earnings ratios (P/E). While these do not give the entire picture of the stock’s performance, they can be effective gauges to see if it falls within an acceptable range of comparable companies. For example, growth stocks tend to have higher P/E Ratios, so you can quickly compare a variety of growth companies by looking at their ratios and market cap.
- Stock Performance (Chart Analysis) – Technical analysis relies on historical stock price movements to predict and track current and future prices. However, remember that past performance does not guarantee future results.
- Analyst Ratings – Many analysts provide regular analyses of different stocks, and if you read a variety of different analyst ratings, you can build a solid opinion of where the market thinks a particular stock is going.
Step 4: Invest
Now that you have a solid understanding of the different types of companies you may want to invest in, it’s time to take the plunge and purchase shares through your preferred broker.
You don’t need to purchase more shares than you can afford, but ideally, you purchase enough to observe how market conditions and corporate announcements impact the share price.
Start by buying shares in companies you know the most about or are the most interested in, and branch off from there.
Picking stocks is a skill that takes time to learn. You need to be comfortable with the risk involved, so you don’t panic sell or trade irrationally.
Conclusion: Picking Stocks
Investing in stocks can seem daunting at first, but once you take the time to understand how the stock market functions and what makes different companies unique, investing becomes much more accessible.
Remember to articulate what you are hoping to achieve out of your investment and then develop a strategy that fits your investing perspective. Once you have your strategy, deploy it on the market and track your progress.
Picking stocks and building your own portfolio takes time, but you will learn so much about yourself and an entire asset class!