How to Pick Stocks

So you want to pick stocks. Well, that’s a broad topic! No worries. We’ll tackle the topic step by step. One thing to be absolutely cognizant of before digging into the various ways you might pick stocks: regardless of the method you use to pick stocks, there is inherent risk in investing in the market. While your investments could increase in value, they could also drop significantly. Just be careful out there.

1. Decide to pick one stock or many stocks

The first thing you need to decide is exactly what stock or stocks you plan to buy. Money burning a hole in your pocket for a slice or two of Apple? Or hoping to invest more broadly in the stock market by picking up a whole basket of stocks for one price? Indulge us in a little straight talk. Historically, picking individual stocks has been a lot like playing the lottery with your life savings. Some perspective: the top performing 4% of stocks accounted for the entire wealth creation of the US stock market since 1926.

For every big stock market winner like Amazon, there have been many, many more loser stocks. Why would that be? Think about it: when you’re buying a stock, you’re buying it from someone who’s selling it. The seller has decided the stock is worth selling at say, $10 dollars a share because she’s sure it’s definitely going to go down, but you’re sure it’s definitely going to go up. Who’s right? What makes you so sure you’re so much smarter than that seller?

On the other hand, the overall stock market, powered by these handful of winners, has over time risen steadily; in the 1880’s, when it was first created, the Dow Jones Industrial Average stood at 62.76, and despite cataclysmic events like the Great Depression and the recent Global Financial Crisis, it now sits well over 20,000. In other words, the smart money’s probably on investing broadly in the market and letting the rising tide lift your investment boat. But, naturally, there will always be gamblers energized by a “go big or go home” mentality. These two methods need not be mutually exclusive however; there’s the much-cited 5% rule that states that a properly diversified portfolio will not contain more than 5% of one stock or sector, so a mostly cautious investor with a wild streak might choose to mostly diversify but also gamble with a little.

The many stocks route

If you choose to buy many stocks at once, you may either choose to follow a passive, or active investment strategy. Passive simply means that no human is involved in managing your investment. The most common way to follow a passive strategy is to purchase ETFs which are bundles of different equities that trade on exchanges just like stocks, and often mirror stock indexes like the S&P 500. The major advantage of ETFs is the low expense. Management expense ratios (MERs) are the percentage of a fund that’s shaved off every year to cover a fund’s expenses. ETFs’ MERs are generally a fraction of those of actively managed investments.

ETFs provide a particularly good method for creating a diversified portfolio. Harry Markowitz, a Nobel Prize winning economist, championed an investment strategy called Modern Portfolio Theory that posits that the key to effective investing is diversification. By investing widely, the theory goes, you’ll enjoy robust stock market results while protecting yourself from crushing downside when a specific stock or sector falls precipitously. The portfolio of a truly diversified investor will include a mix of stocks and bonds, both domestic and foreign, and investments in companies of all sizes in various sectors. If the idea of creating your own well diversified passive portfolio is a big daunting, consider using an automated investing service that will automatically diversify your portfolio based upon your personal goals.

Most mutual funds are actively managed, meaning that there are living, breathing human fund managers who are constantly making decisions about buying and selling the fund’s holdings. Mutual funds come with higher MERs; fund managers need to get paid, after all, and mutual fund holders are expected to cover their salaries and the funds’ expenses. The average MER on American mutual funds is about 1%, in Canada it’s closer to 2%, and the UK’s right in between those two. Ostensibly, the big brained humans running the mutual funds would help them outperform passive funds justifying their considerable MERs. The reality, however, is that tons of studies show that over the long term, the vast majority of professionals paid to pick stocks fail to outperform the market as a whole. The growing public realization of this fact has lead to a massive rush to the exits from active to passive investments. Both mutual funds and ETFs can be purchased in a variety of ways, but the cheapest, easiest way is either through the ETF or fund issuer itself, or one of the big-name discount online trading platforms.

The individual stocks route

If you decide that you’d like to be in the driver’s seat of your stock market investments rather than investing more broadly with an active or passive stock market investment, prepare to work a bit harder to educate yourself on the complexities of how to pick stocks that will rise in value.

“Valuation” is the term used to describe how much stocks are worth (a figure that will likely be different than the price at which a stock is trading.)

Understand that there are two basic ways stocks valuations are determined: a ratio-based approach and an intrinsic value approach. A ratio based approach is concerned with valuing a company by measuring its current share price relative to its earnings per-shared, something that can be accomplished through simple division of the market value per share by a company’s earnings per share. Intrinsic value is a whole lot more complicated, and involves predicting a company’s future cash flows and other factors. Graduate degrees can be earned on topics as big as these.

2. Pick a strategy for choosing stocks

Maybe you love a product like Nike or Netflix or Amazon and you might choose to buy a little bit like your grandparents might have done with a stock like Standard Oil. Choosing a name brand stock this way is probably no worse a strategy than buying shares of a company you’ve never heard of based on the pronouncements of some gin-breathed lout at the bar broadcasting his “can’t lose” stock picks.

You might decide to invest according to your values and only choose stocks that are kind to the earth or invest in a Halal portfolio of stocks that abides by principles of Islamic investing. You could go down the route of value investing (http:) and aim to find investments that might be undervalued with the hope that at some point, the market will see their higher value.

There’s no sure way to make money in stocks, short of inheriting a magic pig that sniffs out tomorrow’s Amazon. Generally, investors with very short investment horizons—like five years or under—should be incredibly cautious about their exposure to stocks if they need to access their funds and instead keep their money in a savings investment account.

3. Seek out value

Naturally, if you’re picking a stock, you’ll want to find one that will sell for more in the future than it’s selling for now. But as valuable as income statements and understanding what a company’s dept situation is like, it’s still a super iffy way to predict where a stock’s price will go.

Unfortunately, it’s very difficult to find underpriced stocks in the same way you might stroll into a department store and find a fly $6,000 Brioni suit in your size marked down to $300 dollars. By the time you decide to buy any stock, the law of supply and demand will have done a pretty thorough job of pricing the stock based on all available information, like revenue growth, earns per share, historical price, etc.

4. Take analysts predications with a big grain of salt

So to pick a good stock, you may choose to listen to the loudest voices on cable news, though history shows that guys like Mad Money’s Jim Cramer are better shouters than stock prognosticators. Analysts sometimes get it right and sometimes get it very wrong.

5. Decide how long you want to hold the stock

With stocks, there’s a lot to be said for holding onto them for a long time. Various studies have shown that those that had the patience to hold stocks for 10 or more years were rewarded with positive returns that offset short-term risks. It’s a pretty simple lesson on how averages will eventually wash out the stock price outliers (which might be either good or bad). In other words, the more time you hold a stock, the less variable its price will be on average. Stocks are never “safe”, and any investment in stocks comes with the real risk you could lose some, or all of your investment.

If you’re not in for the long haul you could hold stocks for a short term or even day trade. Various guides will help arm you with the information you need to day trade, such as the kind of hardware and software required to get started and tips such as start small, trade only a couple stocks per day and consider practicing with imaginary funds first before actually risking any real money.

Bone up on the tax code, as well, which will require you to learn a lot about the Superficial Loss Rule, which, though it might sound like some something that might happen if you de-friend a phony person on Facebook, will actually have great tax implications for you. If you’re changing careers to become a day trader, it will be worthwhile to spend a few bucks and consult a quality accountant before making the leap. Just be aware that day trading is one of the riskiest investment strategies ever. One study showed that in South Korea, 8 of 10 day traders lost money over a six month period. A handful, however, did manage to do quite well.

6. Choose a broker and make the trade

If you’re to buy an individual stock, whatever you choose to buy, in most cases, you’ll need to buy the stock not from the company itself, but instead from a licensed middleman because regular folks can’t just show up at on the floor of a stock exchange to buy a share or two of Apple. They have to employ the services of an investment platform — to buy stocks. You’ll find trading platforms that will execute a trade on the cheap, or even, as a few platform now offer, totally commission-free. Most online services do offer humans to execute trades, but at a price that would probably make it financially unwise for many.

7. Determine the kind of trade you plan to execute

When you’re trading on your own, you’ll have the option of a few different types of trades. The two biggies are market and limit orders. A market order’s the most common; it simply means you’re buying a stock at its current trading price if the market is open, or at whatever price it’s at during the first moments of the next trading session. If the stock’s trading a lot–how much a stock is traded on a particular day is referred to as its “share volume”–there’s a good chance that by the time your order goes through the stock may have deviated from the price you saw. If this concerns you, you might consider a limit order, which means that you will agree to buy a stock, but only when it falls at or below a certain price threshold you set.

8. Execute the trade

Executing a trade is pretty much like the experience you’ve certainly had purchasing a bare-chested Nicholas Cage pillowcase at Amazon. You’ll hit a button, and in all likelihood within a short period of time, the online brokerage will email you a confirmation. If the confirmation comes, you may check to make sure you didn’t somehow miss clicking the button required to pull the trigger on the trade. Pay attention. Just as difficult as it might be not having Nick Cage’s hairy chest to lie your head upon, thinking you own a stock that you don’t is no fun. So always double check!

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