One of the most common questions I get is how to pick which stocks and funds to buy. The simple answer, of course, is that if there was some secret everyone would know about it and would learn how to make money. With that said, there are some basic principles that anyone investing in stocks should consider before making a purchase.
Only Buy Companies You Understand
At the most basic level, when you buy a stock you are buying a piece of that company. Thus, only buy stocks for companies you understand and support. Don’t think of it as just a simple purchase based off of statistical analysis, or simply based off of your impression of the stock. Instead, make the basis of your analysis an assessment of the company itself.
By following that line of logic, don’t purchase companies you don’t understand. If you hear everyone talking about how hot a certain company is, but don’t actually get how that company is making the money it says it is, don’t purchase it. Warren Buffet is a huge believer of this principle and it has certainly proven effective to him. Personally, I would take that a step further by recommending you purchase companies that you use. One of my first stock purchases ever was Dominion Resources (NYSE: D). I picked Dominion (an energy company in Virginia) after writing down a list of businesses I used and knew lots of people around me used. I couldn’t fathom demand for energy decreasing so Dominion made my “short list” after I narrowed down the stock options. Looking further, the stock had a great dividend rate (something I will cover in more depth in a later post) which meant that every three months it paid out a certain amount of money based on the numbers of shares I owned. I of course reinvested that money automatically allowing the amount of stock I owned to grow exponentially. However, at the basic level, I understood how Dominion made its money, I thought that its strategies for the future made sense, and the company was not troubled by any significant scandals or financial problems. You can start investing by doing the same thing yourself.
Buy Low, Sell High
How many times have you heard that adage? What is most remarkable to me, however, is just how many investors do the opposite. As I mentioned in an earlier post, when companies are doing great people buy more of them and are always tempted to sell the company if its stock does poorly. Instead, if you are following the first principle, the company’s stock price shouldn’t matter to you at all. If it’s a solid company, and goes down in price, you buy more.
Right now is the perfect time to start investing. Why? Because the economy stinks right now and no one knows how long that will last. As a result, hundreds of great companies are undervalued. If you’re willing to withstand a shaky stock market for another year and can wait a few years before you see returns then now is a great time to get started. As Buffet says, “Be fearful when others are greedy. Be greedy when others are fearful.”
Buy Index Funds
If you are just getting started in investing, you should buy index mutual funds. The idea is to diversify your holdings as much as possible to reduce risk. If you are rich and have hundreds of thousands of dollars to invest it is fine to pick lots of individual companies. Otherwise, it’s generally better to base your holdings around some mutual funds. With that said, pick a percentage of your investments (such as 25%-40% depending on how confident you are in your abilities not to let short-term losses scare you) to experiment with and go ahead and purchase a company or two you like. Don’t let the purchase fees eat up your profits though, and avoid active trading. If you want to purchase that individual company then make sure you’re planning on holding onto it for a while.
As far as which mutual funds to purchase, the first step is to make sure you are only looking at funds that are free to purchase, and where the fund managers don’t charge high fees. Beyond that, you can pick funds that invest in certain sectors such as finance, international markets, energy, health care, etc.. Feel free to spend some time and decide which sectors you think are good to get into at this point. On the other hand, with an index mutual fund, maybe you will decide that you just want to be even safer and diversify even more by buying funds that attempt to follow the market as a whole. Finally, you can pick funds that are based on the volatility of the stocks the funds hold. Small-cap funds will be far more risky than large-cap funds. With that said, if you pick a good fund, and are investing for the long-term, then the riskier, small-cap, investments are the way to go as historically they have beaten all other kinds of investments.
Regardless of your pick of 1-3 funds to form the portfolio of your foundation, as long as you spend a reasonable amount of time looking into the funds and pick ones that are well diversified, you will protect your self from a lot of risk.
Summary: The Steps
In summary, write down a list of companies you and your friends use. From that list, see if any common themes emerge from size of company to category of business. Narrow that list down a bit more and go ahead and purchase for the long-term. Time that purchase at the time when the stocks are lower, or perhaps a bit less popular, as long as you think the company is still sound.
Finally, at this age, it’s the perfect time to learn from any mistakes you make. Not all the stocks you purchase will go up, but you will learn more from the ones that don’t than the ones that do go up. As long as you remain committed to investing, you will find yourself doing better and better as time goes on.
Nice writing style. Looking forward to reading more from you.
Chris Moran