How to Pick Stocks: 7 Things All Beginners Should Know | Invest

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Picking stocks is an intimidating process. There are 11 different stock market sectors, 69 different industries and more than 8,400 stocks on three major US exchanges. How on earth can anyone – let alone a beginner – intelligently pick specific stocks that are primed to perform well?

Investors should know from the start that there is no foolproof algorithm or formula that will guarantee success. As many stocks as there are, there are thousands more investment philosophies, schemes, strategies, and mindsets that investors use to approach the market.

As a new investor or even a seasoned market participant reviewing your own approach, it is helpful to understand the following principles. Here are seven things to know before picking stocks:

  • Know that you are betting on yourself.
  • know your goals
  • Don’t invest in companies you don’t understand.
  • Understand financial metrics.
  • “If it’s too good to be true…”
  • Assess the “ditch”.
  • Understand systematic risk.

Know that you are betting on yourself

Before you start laying out your plan to become the next Warren Buffett, it’s absolutely critical that you understand the game you’re playing and the odds.

By picking individual stocks, you are banking on your ability to outperform the market and outperform the stock market as a whole. It’s extremely difficult: 84% of professional fund managers whose only job is to beat the index fail to outperform their benchmarks after five years. According to the SPIVA US Scorecard, a study by S&P Global, 95% of managers fail at this task after 20 years.

Maybe small investors have better luck? They don’t, it turns out. In the 20 full years between 2002 and 2021, the S&P 500 grew at an annual rate of 9.5%. According to JP Morgan Asset Management, the average investor earns just 3.6% annually, barely surpassing the 2.2% inflation tax.

Psychological misadventures, such as buying when stocks are up and selling when stocks are down, as well as overtrading, are largely responsible for the pitiful actual returns of everyday investors.

While this principle is arguably the least satisfying of the seven, it is also the most fundamental. By choosing to pick stocks and not buy a low-cost index fund like the Vanguard 500 Index Fund (Ticker: VOO), which automatically gives you market returns, you’re embarking on a bit of hubris and choosing to walk against the odds.

Know your goals

If you still want to pick your own stocks despite the odds, the next step is to outline your goals. Are you a young, bold investor looking to build a multi-million dollar stock portfolio by the time you turn 40? Congratulations, you’ve just narrowed your universe down to high-risk, high-reward names — likely quintessential growth stocks or seedy contrarian names.

Got a shorter runway and just want to play it safe and maybe earn a little income while you’re at it? You’ll probably only want to consider blue-chip companies and dividend-paying stocks; You might find some ideal portfolio pieces among real estate mutual funds or Dividend Aristocrats.

And for those who aim to be short-term momentum investors or trade off charts, your goals are beyond the scope of this article.

Bottom Line: Even a rough idea of ​​your investment goals will go a long way in narrowing down this list of 8,400 choices to the stocks that make sense for your portfolio.

Don’t invest in companies you don’t understand

A share is nothing but a stake in a company. If you were investing in a local small business, would you want to put your money behind it without looking at its books and understanding its income, costs, seasonality, opportunities, risks, competition and benefits?

Good stock picking requires the same level of care and understanding — a concept often repeated by investment greats over time. Warren Buffett has been shouting this proverbially from rooftops for decades, while Peter Lynch, the famous former manager of the Fidelity Magellan Fund, warned to “never invest in an idea that you can’t illustrate with a colored pencil.”

Understand financial metrics

Of course, once you know your goals and come across a good company that you understand, the search doesn’t end there. You need to have an idea of ​​whether the stock itself is cheap or expensive.

Financial key figures help here – derived from the market value of the share and various figures from the balance sheet, income statement and cash flow statement. Valuation metrics such as price-earnings, price-sales, and price-book are some well-known examples, but other metrics can help convey how well a company is able to pay its debts, how profitable its operations are, and how efficient it is.

While it’s not necessary to review all of the financial metrics before investing in a company, you should know where the important ones compare to your peers — and where they’re headed.

“If it’s too good to be true…”

If it’s too good to be true, it probably is. This old aphorism applies in the stock market, where many treacherous temptations can await investors. A common mistake newer investors can make is to be lured into stocks with attractive valuation multiples, most commonly price-to-earnings, or P/E.

Cyclical companies like homebuilders, automakers, and banks can occasionally trade at much lower P/E ratios than the rest of the market, making them look cheap. But just because PulteGroup Inc. (PHM), Ford Motor Co. (F), or Citigroup Inc. (C) is trading at single-digit P/E ratios doesn’t mean those stocks are oversold. In fact, the market may be signaling that the peak of the winning cycle is in the rearview mirror and the trailing gains are much higher than can be expected going forward. These types of seemingly cheap stocks are known as “value traps.”

Another inclination of many investors is the desire for high dividend yields. While a good high-yield blue-chip stock can pay a dividend of 2% to 4%, many names in the market could yield 7% or more.

Meteoric returns are typically a warning sign: Often, either the stock itself has fallen dramatically for a good reason, or past dividends are considered unsustainable and a dividend cut or cancellation is expected.

Judge the “trench”

Above all, if you want a set-it-and-forget-it portfolio, you should choose stocks in companies that have long-term competitive advantages that set them apart from the broader market. Warren Buffett refers to these perks as “moats” that protect the corporate stronghold.

In essence, large economic moats help companies continue to thrive and protect their margins over the long term.

For example, Coca-Cola Co. (KO) moats include its globally recognized brand and distribution network. Apple Inc. (AAPL) also has an enviable global brand, network effects that make its products more useful the more people use them, and high switching costs as users would be forced to adapt new software and buy new compatible accessories when they move to one would change competitors.

The extent of a company’s moat affects the price investors are willing to pay for the company’s stock, as wider moats are more valuable.

Understand systematic risk

The last thing to know about picking stocks is that your portfolio often rises and falls for reasons unrelated to the specific stocks you own. This year provided a great example of systematic risk in action as all three major US stock market indices entered bear markets as inflation, war and rising interest rates flattened stocks.

These external factors, which no single company or board of directors can control or avoid, can drag down even well-chosen, long-term stock picks. Eliminating this broader market risk is impossible, but investors can mitigate company-specific risks through diversification.

While systematic risk is a part of life, investors can address it by buying stocks with a lower correlation to the market, known as low-beta stocks, or engage in it by selecting high-beta stocks. Beta measures the volatility of the broader stock market, which is always 1.

While beta is not a perfect metric, stocks with betas below 1 generally move less sharply when markets rise or fall, while the opposite is true for high beta stocks. In theory, this makes low-beta stocks preferable in bear markets and high-beta stocks better options in bull markets.

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