Picking stocks is an intimidating process. There are 11 different stock market sectors, 69 distinct industries, more than 8,000 securities and more than 4,000 listed companies across the major U.S. exchanges. How on earth can anyone – let alone a beginner – go about intelligently choosing specific stocks that are primed to do well?
Right off the bat, investors should know there's no foolproof algorithm or formula that will ensure success. As many stocks as there are, there are thousands more investing philosophies, schemes, strategies and mindsets that investors use to approach the market.
As a newer investor, or even as an experienced market participant reexamining your own approach, it's helpful to understand the following principles. Here are five things you should know before picking stocks:
- Nothing is guaranteed.
- Know you're betting on yourself.
- Know your goals, timeframe and risk tolerance.
- Research, research, research.
- Keep your emotions in check.
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Nothing in the Stock Market Is
Guaranteed
The first thing for beginning investors to know about
picking stocks is that in the realm of investing, nothing is guaranteed.
"No one has a crystal ball to know if a stock will
perform well," says Diane Kessler, a senior wealth advisor at Citi
Personal Wealth Management. "This is why stock picking should be done with
caution, and investors should be cognizant that the market is full of
surprises."
The best way to prepare for these surprises is through
diversification, she says. Owning stocks from a variety of sectors can add
stability to your portfolio because when one sector is beat down, another is
likely to thrive.
But how many stocks does a diversified
portfolio require? According to Andrew Crowell, a financial
advisor and vice chairman of wealth management at D.A. Davidson, stock
investors should own at least five to 10 different positions, so that no one
position accounts for more than 10% to 20% of the total portfolio.
Just remember that "diversification does not guarantee
a profit or protect against loss," Kessler adds. While over the long term,
the stock market has historically trended up, you're likely to experience bumps
along the way. Never invest money you can't afford to lose.
Know You're Betting on Yourself
Before you start devising your plan to become the
next Warren Buffett,
it's absolutely vital that you understand the game you're playing and what the
odds are.
By opting to pick individual stocks, you're betting on your
ability to beat the market and exceed the return of the stock market at
large. This is extremely difficult to do: more than 86% of U.S. large-cap
professional fund managers, whose entire job is to beat the S&P 500 index,
fail to outperform their benchmarks after a five-year period. After a 15-year
period, more than 92% of managers fail at that task, according to the SPIVA
U.S. Scorecard, a study by S&P Global.
Individual investors face even bigger hurdles to success
and not just because they don't have the luxury of dedicating their entire
working life to studying investments. Psychological mishaps like buying when
stocks are on a run and selling when they're down, as well as overtrading, are
largely to blame for the miserable actualized returns of everyday investors.
So, while this principle is arguably the least satisfying
of the five, it's also the most fundamentally important. By choosing to pick
stocks and not buying a low-cost index fund like
the Vanguard 500 Index Fund (ticker: VOO)
that automatically earns you market returns, you're engaging in a bit of hubris
and choosing to go against the odds.
Know Your Goals, Timeframe and Risk
Tolerance
If you still wish to pick your own stocks despite the odds,
the next step is to outline your goals, timeframe and risk tolerance. "Are
you an investor looking for growth of capital, or are you seeking periodic
income from your investment?" asks James Sahagian, a certified financial
planner and managing director of Ramapo Wealth Advisors at Steward Partners.
"What kind of volatility are you comfortable with?"
If you're a young, swing-for-the-fences investor who wants
to amass a multimillion-dollar stock portfolio by the time you're 40, you've
just narrowed your universe down to high-risk,
high-reward names – likely out-and-out growth stocks or
beaten-down contrarian names.
If you have a shorter runway, and simply desire to play it
safe and maybe earn a little income while you're at it, you'll likely only want
to consider blue-chip companies and
dividend stocks.
And for those aiming to be short-term momentum investors or
trade based on charts, your aims are beyond the purview of this piece.
The bottom line: Having even a loose idea of your investing
goals will be a big help in culling down that list of 8,000 choices to
the securities that
make sense for your portfolio.
Research, Research, Research
Now that you have an idea of what you're looking for, the
real homework can begin. "No one makes a purchase of a product or service
without knowing what it is and what they hope to get from it," Crowell
says. "The same philosophy applies to investing."
He says to ask yourself what you know about this company
and why you're choosing to invest in it. Brokerage firms often
provide research reports to clients that can help you gather key information
about a company from a professional's point of view, but you should also delve
into the company's financials yourself.
The company’s revenue growth, profitability, debt levels,
return on equity, position within its industry and the health of its industry
are all metrics you should
consider prior to making an investment, Sahagian says. You can also
benchmark the stock against an industry index and the overall market to help
you determine if it's the right time to invest.
"While a rising tide may lift most boats, a falling
tide can sink most ships," he says. "Determining when to invest in
certain industries or stocks can improve your investment success."
Keep Your Emotions in Check
Once you start investing, long-term success requires
keeping your emotions in check, Crowell says. This is in large part due to
the cyclical nature of
the economy and stock market. Contractions are inevitable, and
they don't mean you need to abandon all investments along with your hope for
retirement.
"Instead of panicking during a downturn, thoughtful
investors should review their holdings and potentially add to or rebalance
their portfolio," Crowell says. "Ask yourself (if) the prospects for
the companies you own really changed for the long term, or is the sell-off
simply a reflection of a temporary economic slowdown which will eventually end
and then rebound?"
Successful long-term investors need an iron will to go
along with their iron stomach and resist the urge to sell at the worst of times
only to be forced to buy back in the best of times.
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