So you're ready to take the plunge and start investing in individual stocks. How do you choose which securities to invest in? It's like being sent into Walmart with vague instructions to “buy something good.”
Perhaps you already own mutual funds or exchange-traded funds (ETFs) that represent a “basket” of stocks — possibly an entire market, such as a Total Stock Market index fund — but you want to try your hand at buying individual stocks.
Or maybe this is your first expedition into any type of investing, and you want to choose your own stocks rather than allowing fund managers to make those decisions for you.
In this article, we tackle the subject of how to select your first stock to buy, along with some tips about what to avoid. As with anything regarding investing, particularly the stock market, remember there's no such thing as a sure thing.
Like Throwing a Dart?
Years ago, The Wall Street Journal ran a contest. A professional money manager would pick a stock. Someone else would throw a dart at the stock listings in that day's newspaper.
After a few months, the Journal reported which stock had a higher return for the period, the one chosen by the pro or the one selected by the dart.
As you might expect, the dart often won.
There are more than 3,000 stocks traded in the U.S. Don't just throw a dart at a list of them. Here are some suggestions for narrowing down the list of stocks you may want to buy. These tips will help improve the chances that you'll pick a share that delivers a decent return.
Begin With What You Know
Start by identifying a few industries you know something about. Maybe you're a technology addict or a slave to fashion. Or perhaps you're a frequent business traveler who knows firsthand about various hotel chains.
Next, go to an online stock screening tool that lists companies by industry, such as Yahoo!Finance's “Industries” tab. (Although other aspects of Yahoo! have suffered, its Finance site is incredibly useful.) You should be able to drill down to a list of the companies in a chosen industry. You'll recognize some but not all of the companies in any industry. But you don't want to buy a stock just because the name is familiar.
A stock screener allows you to screen and sort the stocks in your chosen industry according to a variety of characteristics. For example, you can filter by company size, specific financial measures, dividends (not all stocks pay them), or even how a company is rated by environmentally-focused rating systems.
Is Now a Good Time?
The oldest piece of investment advice is “Buy low; sell high.” It is impossible to know if today's stock price is low or high compared to where it “should” be. But you don't want to buy a stock whose price is very high unless you are convinced the current high rate is just the beginning of what will be an even more significant run-up.
Now for the tricky part: How can you know that a stock's current price is “high”?
It certainly doesn't mean anything if the price of Stock A is higher (or lower) than the rates of Stocks B, C and D. It's somewhat useful to know if Stock A's current price is close to its high or low over the past 52 weeks. Most stock screeners show you this, but it's not a way to choose a stock.
A more useful measure of whether or not a stock's current price is fairly high is the P/E ratio (price-to-earnings ratio). Any stock analysis app or website should provide this.
P/E ratios have ranged from about 15 to 24 since the Financial Crisis. If an individual stock's P/E ratio is much higher than the average for the overall market, that's a flag. Not necessarily a flaming-red flag, but a flag. It means the stock's price is high compared to most other stocks, given the company's earnings over the past 12 months. This may indicate that investors think the company's revenues will grow a lot. If so, that would justify the high price. But that's something you'll want to investigate next.
Further Reading >> How to Invest in Stocks
Narrow It Down
Find a couple of stocks with P/E ratios that are not too high and not too low. It's a good idea to focus on companies you know something about. Narrow down your choices to just a few, then do a bit of reading about each one. Analyst reports are an excellent way to learn about the outlook for a business without the slick marketing message, “Everything's great here,” you get from a company's website.
If you know how to read financial statements, take a look at key metrics such as ROE, profit margins and earnings growth. Your goal is to decide whether you think the company is well managed, is a strong competitor in its arena, and is likely to prosper in the coming years.
Alternatively, you can skip the industry-based approach and make a list of a handful of companies whose products or services you like: athletic apparel, theme parks, organic food, farm equipment, etc. Check their P/E ratios, narrow down your list, read a few analyst reports, and make a choice.
Don't Worry About Charts
You may hear people talk about buying or selling based on charts of a stock's recent price moves. That's more about trading — buying or selling over a reasonably short period of time-based on patterns seen in those charts — and less about choosing a stock to buy for the long term. You want to buy a stock to hold for many years. As noted earlier, if a stock has a high P/E ratio, you should find out why before you buy, but otherwise, don't try to time your purchase.
How not to Choose a Stock
Here are some things to avoid in choosing a stock, whether this is your first time or you've been doing this for a while:
1. Don't get emotional.
You don't want to buy stock in a company because you love their commercials or because your grandfather owned the stock decades ago. Keep emotions out of the decision. You want to buy a stock that is likely to do well going forward.
2. Don't buy (or sell) a stock based on inside information.
It is illegal for you to trade any stock (or options on the stock) based on inside information. This is material (nontrivial) information about a company that has not been announced publicly. Maybe it's something about a big new contract or a breakthrough technology or a plan to acquire another company. Don't be tempted to trade on such information, even if it comes from your friend. The Securities and Exchange Commission (SEC) is very good at uncovering insider trading. You could lose any profits you made from the trade, have to pay penalties and even go to jail.
3. Don't buy a stock based on a recommendation from a guy at the gym, a cab (or ride-share) driver, your dentist or anyone else who has no expertise in this area.
And even if it is your broker who recommends a stock, you still need to do your own research. Brokers are not obligated to look out for your best interest.
4. Don't buy a stock just because it has been going up a lot.
Sometimes investors get overly excited about a stock, and the price goes up for no good reason. You don't want to be the last one to the party. Some fairly sophisticated funds use “Momentum Strategies” that buy and sell stocks based on recent trends. Research shows they can be quite successful, but it requires discipline to manage this type of strategy. If you try to do this on your own, you're likely to hold on too long. If you think that sounds bad, you're right.
Don't buy just one stock. If you want to build your own stock portfolio, you need to diversify your risk. Your goal should be to hold around 20 stocks across different industries, so you don't have too many of your eggs in one basket. Buy for the long term, focusing on businesses that are well managed and have excellent opportunities. Remember, buying stock means you own part of the company!