Picking stocks is an intimidating process. There are 11 different stock market sectors, 69 distinct industries and thousands of publicly traded companies across the major U.S. exchanges. How on earth can anyone — let alone a beginner — pick stocks that are primed to do well?
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Right off the bat, you 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 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, time frame and risk tolerance.
— Research, research, research.
— Keep your emotions in check.
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, and any one position shouldn’t account 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 you understand the game you’re playing and the odds.
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: Nearly 85% 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 10-year period, 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, Time Frame 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.
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 choices to the securities that make sense for your portfolio.
[READ: Should Investors Have Multiple Brokerage Accounts?]
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.”
Due diligence is key to picking stocks, Kessler says. “Professional investors take the time to review companies’ financial reports and consider analysts’ opinions before making any investment decisions.”
There are two primary strategies investors use to research stocks: fundamental analysis and technical analysis.
“Typically, fundamental analysis is used to make (or) validate longer-term investment decisions, whereas technical analysis is more often used for shorter-term trading decisions,” Crowell says.
Fundamental Analysis
Fundamental analysis evaluates a stock based on the merits of the company behind it.
Investors use company annual reports, quarterly conference calls and third-party databases to analyze a company’s vital signs, such as earnings growth, profitability and revenue growth, Crowell says. They may also compare a company’s metrics to that of “peers to decide what a reasonable price is for the shares.”
He says some common fundamental indicators to pay attention to include:
— Price-to-earnings (P/E) ratio: This is the stock’s current price divided by the company’s earnings per share, or EPS. It tells you how much you are paying for each dollar of earnings. Lower is typically better, but industries differ in what is “typical.”
— Price-to-sales (P/S) ratio: If a company doesn’t have enough earnings history to make the P/E ratio meaningful, P/S is a good alternative. This measures a company’s price relative to its revenue. It can also be a better metric when comparing companies in industries with revenue as a key driver, such as tech startups or high-growth stocks. A high P/S can be a sign a stock is overvalued.
— Price-to-book (P/B) ratio: Another alternative or supplement for the previous ratios is the P/B ratio. It shows the price investors are willing to pay per dollar of company assets, and it can be useful in evaluating companies with substantial tangible assets like real estate firms or banks. Lower is again better if you’re looking for value.
— Price/earnings-to-growth (PEG) ratio: The PEG ratio adjusts P/E to account for a company’s expected earnings growth. As a result, some would say PEG paints a more accurate picture than P/E. PEG is calculated as the P/E ratio divided by the expected annual EPS growth. “PEG ratios higher than one generally are considered expensive, so many investors look for PEGs of one or less,” Crowell says.
You can compare these metrics across companies to see how a stock stacks up against its peers. But you can also look at how a company’s metrics have changed over time to gauge how it’s progressing.
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.
“As long as the fundamentals show that the intrinsic value of a stock is much higher than the current share price, an investor may continue to hold the shares,” Crowell says.
Technical Analysis
Technical analysis focuses on the stock rather than the company. It uses historical trading data, such as a stock’s price and trading volume, to try to predict its future price direction by looking for trends or patterns. This may be the style for you if you love analyzing charts. Lots and lots of charts.
Investors who subscribe to this strategy believe that stock charts “reflect the collective wisdom of a wide marketplace of investors,” Crowell says.
To learn more about technical analysis and the different indicators you can be using to screen for or pick stocks, be sure to read up on how to analyze stock charts.
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.
“While not true every month or even every year, the S&P 500 index has always gone on to achieve new all-time highs,” Crowell says. The stock market has clawed its way out of very deep trenches, and will likely continue to do so.
“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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How to Pick Stocks: 5 Things All Beginner Investors Should Know originally appeared on usnews.com
Update 02/14/25: This story was published at an earlier date and has been updated with new information.
