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Picking Stocks: A How-to Guide

With so many different options to choose from, picking stocks can be hard for any investor, much less someone new to trading. While each investor has their own set of goals, which can alter their strategy for investing, having a clear set of rules for how to pick stocks can help guide their decisions.

  • The stock market gives investors multiple ways to generate income while diversifying their portfolios and avoiding overly conservative investment strategies.

  • Choose an industry you’re interested in or familiar with and stay on top of industry news and expert opinions.

  • Diversify your portfolio with different industries and types of investments.

Benefits of Investing in Stocks

Image via Flickr by AndreasPoike

Stocks can be a valuable part of any investment portfolio. Because there are risks for investing in the stock market, it’s essential to understand the relationship between risk and return for investing in stocks as well as to be aware of your own tolerance for risks. Let’s take a look at three main benefits for investing in stocks:

Stay Ahead of Inflation

Stocks historically average an annualized return of 10% — better than the inflation rate of 2.9%. However, it does mean that you have to have a longer time horizon so you can buy and hold on to stocks for an extended period if the value drops temporarily.

Earn Income in Two Ways

There are two different ways you can earn money by trading stocks. In general, investors have a goal of buying low and selling high. They may look for fast-growing companies and intend to take advantage of short-term trends. However, these companies are also attractive to buy-and-hold inventors, as they expect to see the company’s stock prices and earnings grow over time. The other way investors make money on stocks is by purchasing the stocks of companies that pay dividends, allowing them to enjoy a regular stream of cash from their investments.

Diversification

For investors who put their money in different kinds of investment products, investing in the stock market gives them the benefit of diversification. Those stock market investments change in value independently of bonds, real estate, and other types of investment products. By holding on to stocks for a long time, you can weather the losses you may experience in other investments during downward trends. While stocks do create risk for an investor’s portfolio, they also create the potential for large, rapid gains.

Investing in stocks can help risk-averse investors avoid overly conservative investment strategies.

How To Pick a Stock

S mart investors decide in advance what they want to achieve with their portfolios and stick with that decision. They stay on top of trends, events, and daily news, recognizing that these things heavily impact the stock market and drive the economy. They use their goals and knowledge of current and upcoming events to make informed decisions about the stock they’re buying and selling. So how do you become a smart stock-picker?

Identify Your Goals

The first step for picking stocks to invest in is determining what your goal is for your portfolio. Sure, you want to make money. Every investor wants that. However, as an example, you may be focused on generating income to help supplement your retirement, on capital appreciation, or in preserving your wealth.

Select a Strategy That Matches Your Goal

In general, there are three different kinds of investors: income-oriented investors, those who aim for wealth preservation, and those who are looking for capital appreciation.

Investors who are focused on generating retirement income generally use a strategy of buying and holding on to stocks that pay regular dividends. These types of stocks tend to be low-growth companies like utility companies. However, other options could include master limited partnerships, high-rated bonds, and real estate investment trusts.

Investors who have a goal of wealth preservation generally have a low risk tolerance. They often invest in companies that perform well regardless of what the economy is doing. They typically don’t chase initial public offerings (IPOs).

Investors who are focused on capital appreciation are usually willing to accept higher degrees of risk for the opportunity to take advantage of significant gains. They look for companies that are in the early years of growth.

Diversify Your Portfolio

To be clear, a savvy investor uses a combination of any of the strategies identified above to diversify their portfolio. A conservative investor may still devote a portion of their portfolio to high-growth stocks. In contrast, a more aggressive investor could still set aside some of their portfolio for slow-growth, stable investments to offset any losses.

Stay on Top of the News

Read the financial news and stay up to date with the top industry blogs whose views are of interest to you. The information you gather through your research will become the foundation for your investment strategy. It’s also essential for picking stocks.

Perform a Basic Analysis

Take a step back and evaluate the demand for a product or service. It’s a safe assumption, for example, that if the demand for a product is increasing, some of the companies that produce the product will perform well. However, it’s also important to be critical of your theories and assumptions. For example, just because a product performs well in the U.S. doesn’t mean that people in Asia will be clamoring for it, too.

Find Companies To Invest In

The next step is to find companies to invest in. You can do this by locating and tracking the performance of exchange-traded funds. Identify an industry that’s of interest to you and see the stocks that they’re investing in. You can easily do this by searching online for “Industry [type] EFT.” The EFT page will tell you the fund’s top holdings.

Another way you can find companies is to use a screener to filter stocks based on sector, industry, or other specific criteria. When you use a screener, you can modify the filter to sort for companies based on dividend yield, market cap, and other metrics.

You could also find companies by looking through financial news releases, stock analysis articles, blog articles, and other commentaries on companies that you’re thinking about targeting. Be critical of everything that you read and consider both sides of every argument.

While performing research and seeking out expert opinions on the market is time-consuming, it’s usually worth the effort. Not only will it help you better understand industry fundamentals, but it can also help you find out about smaller companies that might not show up on screeners or appear within EFT holdings.

Review Investor Presentations

Once you’ve familiarized yourself with the major players in an industry, review the investor presentations. These presentations are less comprehensive than a company’s financial statements but will still give you an overview of how it makes its money. Investor presentations are also much easier to absorb than 10-K and 10-Q reports.

Tips for Picking Stocks

While the steps for picking stocks may seem pretty basic, there are some other important tips to keep in mind when you’re buying and selling stocks.

Invest in Stocks With Straightforward Business Models

You should consider investing in stocks that have straightforward, easy-to-understand business models. Additionally, if you happen to have more in-depth knowledge of a specific industry or know about a company that other investors might find complicated, you should consider looking at those industries or companies, as well.

Anchor Your Portfolio With Index Funds

Index funds can be an excellent first investment for a trader because they allow you to gain exposure to the stock market without buying all the stocks in the index. These index funds could be exchange-traded funds or mutual funds. Index funds offer less volatile returns, have low management fees, and are easy to buy. They also allow you to diversify your portfolio to reduce your risk, lowering the likelihood that you’ll be burned by a single investment.

Invest in Individual Stocks

Find companies you think will see growth over the coming weeks, months, or years and gain a solid understanding of their background and how they make money. If you’re new to buying stocks, you may want to start small, keeping in mind that firsthand experience is the best kind of education when you’re getting into trading.

Focus on Multiple Industries

While it may be tempting to focus only on industries you understand, you don’t want to overload your portfolio only with stocks from a small number of industries. For example, if you work in information technology, you may be tempted to fill your portfolio with tech stocks. However, every market is going to be subject to the ups and downs of the economy. If you primarily own stocks in just a few sectors, those market dips are going to hurt more. A better strategy is to diversify your portfolio across six or seven different industries.

Keep Dividends in Mind

A dividend is a distribution of profits by a corporation to shareholders. If a company is profitable, it can pay a portion of those profits to shareholders — a payment referred to as a dividend. Dividends allow you to make an immediate return on your investment so that you aren’t entirely reliant on capital gains. Not just that, companies that pay dividends are healthy. They can maintain operations and possibly even expand while still paying dividends to their investors.

It’s important to remember that even with the best strategy, there are no guarantees for picking winning stocks. It’s best to approach investing with a consistent strategy for how you will pick stocks. This will improve the likelihood of picking great stocks and will help you win more than you lose.