Selecting a stock is not unlike shopping for most big purchases. You research the product, compare it to others for fit, quality, relative value and so on — perhaps compromising in some areas but not in others. Over time, you may become savvy enough to spot value or a prized possession easily.
You can approach stocks by looking to “buy what you know,” but you should also know what you’re buying from an investment standpoint. There are many lenses through which to view stocks, strategies to compare them and ways to hold them. Your goals as an investor can help determine how you analyze and hold stocks.
Here are some essential strategies to help you learn how to pick stocks.
1. Investment styles: Growth, income and value
For some investors, stock picking is all about finding stocks that fit a certain investment style.
Growth investors are looking for the next big thing, and are usually willing to pay a high price for a stock with future potential value. Companies in growth mode are reinvesting earnings and expanding quickly through hiring, new products, acquisitions and capital appreciation. Growth stocks tend to be more aggressive — as more investors drive up the price, it amplifies the risk that they won’t meet growth expectations for their valuation.
Income investors seek companies paying regular income to shareholders in the form of dividends. Even if you don’t need the income now, reinvested dividends function like regular returns that can help grow your investment. Income stocks tend to be found in older, more established firms, which may already be past peak growth years but are profitable and generally well run.
Value investors attempt to find underpriced bargains; that is, companies with underlying value not reflected in the share price. Specifically, they look for stocks with lower price-to-earnings ratios than the overall market, hoping the price will rebound. These are shares of companies that may no longer be in growth mode or may just have fallen out of favor. Value stocks are also more likely to pay dividends.
2. For long-term investors: Fundamental analysis
If you are looking for companies to invest in for an extended period of time, digging into the fundamentals can be a good way to understand its financial health and get to know the stock. Even if you’re not a business whiz, understanding these concepts and tracking them over time can help you compare the stocks of similar companies against one another.
|Company fundamental||What it is||What it tells you|
|Revenue||How much money is coming into the company.||If the company is growing. Increasing revenue year-over-year is generally a sign of growth, although it doesn’t necessarily mean increased profits.|
|Earnings per share (EPS)||The company’s earnings divided by the total number of shares outstanding.||How much of the company’s profits are returned to shareholders.|
|Price-to-earnings (P/E) ratio||The market value of the stock (or current price) divided by EPS.||How much of a multiple investors are willing to pay for a share of the stock. A P/E ratio of 20 to 25 means investors will pay $20 to $25 for every $1 of earnings. High P/E can be a sign the stock will continue to grow or it may be overpriced. Low P/E may indicate a stock is undervalued.|
|Price/earnings to growth (PEG) ratio||The stock’s P/E ratio divided by expected 12-month growth.||If the stock is fairly valued. While P/E ratio doesn’t account for a company’s growth, PEG does. A PEG of one is thought to be fairly valued, greater than one is expensive and less than one is undervalued.|
|Return on equity (ROE)||Net income divided by average shareholder equity (which represents the company’s total assets minus liabilities).||How efficient management is at passing earnings on to shareholders. ROE is expressed as a percentage. Investors may tend to stick to a percentage near the S&P 500, which was about 15.6% in 2017.|
Many publicly traded companies file annual audited 10-K financials with the Securities and Exchange Commission (SEC), along with quarterly 10-Q updates. In these documents, investors can see a company’s revenue, debt, cash flow management and other metrics. Many financial websites and online brokerage platforms will provide fundamentals as part of their basic stock quote information, as well as access to analyst research and recommendations. Analyst reports often help add qualitative information to your research, such as competition, new products or brand equity.
3. For active investors: Technical analysis
Short-term investors and active traders making bets on what will happen shortly rely on something called technical analysis, which ignores the fundamental value of a stock and instead pays attention to moves in stock price or other types of trading data.
Technical analysis assumes that all information to be known about the stock is built into its price, and prices tend to follow certain repetitive patterns or trends due to investor psychology. These trends may come in the form of tides lasting a year or more, waves lasting one to three months or ripples lasting less than a month.
Investors chart a stock’s trading activity in different ways to uncover certain trend lines and that may be predictors of future moves:
- Line charts track a stock’s closing price over longer periods, providing a broad view of the stock’s performance.
- Bar charts give a sense of a stock’s daily movements, or opening price, high price, low price and closing price (OHLC). This view can provide a sense of a stock’s volatility.
- Candlestick charts are similar to bar charts, with clear illustrations of the stock’s opening and closing prices. If the stock price closes higher than it opens, the difference or “wick” is positive.
A stock experiencing increasingly higher highs and higher lows over time is considered to be on an upward trend, and descending highs and lower lows would signal a downward trend. A sideways trend means that prices have been moving in the same general range. Looking at these charts, investors attempt to find levels of resistance, meaning points at which the stock may stop trending higher, or levels of support, meaning there’s strong enough demand to keep a stock from trending further downward.
Technical analysis can be complicated, which is why many active investors rely on tools offered by online brokers to help spot technical trends.
4. Broad stock picking: Diversified stock portfolios
An easy way to pick stocks is to buy many at once through an exchange-traded fund (ETF). These investments offer mutual fund-like diversification, but they trade like stocks. That means you can buy shares of the Standard & Poor’s 500 or NASDAQ 100 in the same way you might buy shares of Coca-Cola or Apple.
But ETFs come in many other shapes and sizes: You could use a handful of sector ETFs to build a full stock portfolio or balance stock holdings with a bond ETF. Interested in dabbling in commodities, currencies or hedge funds? There are ETFs covering alternative investments as well.
You can purchase ETFs through a broker, which means you might pay a transaction fee when you buy and sell them. Otherwise, ETFs tend to be very low-cost for investors who buy and hold.
Figuring out how to pick stocks seems to be as much about talent as skill, and even the most brilliant stock analysts can’t see around every corner. For the average person, investing in an ETF or mutual fund allows you to own stocks without having to select individual shares. You may not get the same shopper’s high, but there’s also less of a chance you’ll regret your purchase.
If you are determined to own individual stocks, it makes sense to start small and build slowly as your confidence in stock investing grows. You can even start with no money and a completely hypothetical portfolio. There are many stock market simulators online to help you experience stock trading without the risk. Either way, until you understand your appetite for volatility, individual stock investors should only risk excess or “fun money” you can afford to lose.