If you’re just getting started, investing in stocks may seem daunting. There are so many things to look out for that you don’t know where to begin when you pick stocks. You hear stories of investors who turned a couple of thousand dollars of real estate into millions in a year. Or, investors who delved into penny stocks and hit the jackpot.
In the short term, this is not very realistic. For every investor who got lucky one year, there are thousands who didn’t. Playing that game is not a strategy that will help you achieve financial freedom with any degree of security.
On the other hand, taking a more pragmatic approach and investing systematically in stocks can be very rewarding. This approach allows you to achieve more reasonable results both in the short and the long term.
In this post, I will go over everything you need to know to make your first pick of stocks, including everything from finding companies, determining your risk tolerance, company metrics, and building a diversified portfolio.
This type of investment focuses on generating a steady stream of income. Income-generating investments are great for the short-term and can help you pay for daily expenses and start building your savings. These investments usually have a much lower entry barrier than wealth creation investments, lower risk, and, consequently, much lower long-term prospects. For that reason, these types of investments are usually a stepping stone to more profitable investments. They are best for young people looking to gain stability and retirement-age people looking for low-risk investments.
There are many ways to invest for income generation, the most common being high dividend-paying stocks and bonds.
Some other examples of income-generating investments are real estate apartment buildings. A platform like CrowdStreet invests in these types of properties and generates regular income in the form of rent. It pays out quarterly dividends to investors and, as with most REITs, comes with generous tax benefits and tax breaks,
After you’ve generated some income, it’s time to change the approach. Income generation is excellent in the short term but won’t help you achieve financial freedom.
Wealth creation investments focus not on generating income but on the market value of your assets. These are long-term investments - think 3-, 5-, or even 10-year investments - that increase their value as time passes. Good quality assets can make you very wealthy in the long run, but bad investments and the inherent volatility of long-term investments can make for a risky endeavor.
One of the most common investment strategies for long-term wealth in the US is real estate investments. In 2021, Over 28% of Americans chose real estate as their primary long-term investment.
When it comes to wealth creation, real estate takes on a different compared to income generation. For starters, it has a stronger focus on acquiring properties and increasing their value by renovating or building in areas with high potential for appreciation. Until a couple of years ago, this kind of investment was available only for the wealthy, but nowadays, platforms like Groundfloor make it accessible for everyday investors.
However, despite being the preferred option for long-term investments in America, it’s not the best. The best way to build long-term wealth is to invest in the stock market, according to experts.
One of the first recommendations you might have heard: never invest in a business you can’t understand. Warren Buffet coined this term, and it’s sound advice for individual investors.
Suppose you buy a stock. Now you have partial ownership of that business; you can hardly make the best decisions if you don’t understand the business model. A good starting point to begin your research is to look at everyday services and everyday products you buy. From the most obvious, like the smartphone in your hand, the clothes you wear, the wine you drink, and the car you drive, to services like streaming platforms, computer software, or the electricity provider that powers your home.
There’s a company behind every one of those; the first step is to pick a couple of them and start learning about their business model.
Risk is a very important concept when it comes to investing. Usually, there is a direct relationship between risk and reward: the higher the risk, the higher the reward, and vice versa. The main reason for this is that volatility is a two-way street: investments that can gain a lot of value in the short term can also lose it in the short time. More about risk profiling here.
A good rule of thumb is to have a higher risk tolerance and take on more risky - and potentially more rewarding - investments when you’re younger, as you will have more time to make up for any downturn in the market with your regular income.
On the other hand, when you’re older, you rely more on your savings and not so much on regular income - in this case, your risk tolerance for any investment should be lower.
A similar thing applies to companies. Before you start investing in any company, check the types of risk associated with the industry:
This type of risk is unique to every company and is not related to the market as a whole. Some examples of business risk are recalled products, layoffs or strikes, loss of important suppliers or customers, and more. All these factors are considered business risks and are mostly unpredictable.
If it can’t be predicted, how can you prepare for it? Research. Look for companies that are prepared and have plans in place. The ideal company should have an answer to questions like What happens if we lose our leading supplier? And, how can we adapt to customers changing their tastes?
Market risk refers to the overall daily fluctuations of stock prices, foreign exchange rates, interest rates, and commodity prices. It can be industry-specific or affect the stock market; a good way to protect against this type of risk is to diversify investments across many sectors. A variety of security that has historically maintained its value, even during times of heavy market unrest, is precious metals. Platforms like Money Metals and APMEX make it very easy for investors in the US to gain exposure to this market.
After you’ve assessed the risks associated with one of your potential investments, it’s time to look at some numbers. Here are the metrics you should consider when picking a stock:
The price-to-earnings ratio, also known as P/E ratio, measures the relationship between the market value of a stock (i.e., how much people are willing to pay for a share) and how much the company is earning (i.e., net earnings of the company). It’s calculated simply as the quotient of the price of a stock divided by the net profits.
This number can indicate whether a stock is overvalued or undervalued; if the quotient is high, that means the value of the stock is high compared to earnings, which may indicate the stock is overvalued (i.e., the stock is too expensive).
On the other hand, if the quotient is a small number, it indicates the earnings are disproportionately large compared to the stock price. In that case, the stock could be undervalued (i.e., the stock is cheap), and it could prove a good investment.
The main purpose of the P/E ratio is to get an idea of where the stock is. Ideally, you will avoid overvalued stocks and invest in undervalued ones that have the potential to increase in value.
The price-to-sales ratio, also known as the P/S ratio, measures the relationship between a company’s market capitalization (i.e., number of shares times the price of a share) and how much the company earned in the last year (i.e., net earnings for the previous 12 months). Similarly to the P/E ratio, the P/S ratio is calculated as the quotient of the market capitalization divided by the net earnings.
This number indicates how much an investor has to invest, in dollars, for every dollar of revenue. A P/S ratio over 1 indicates the market capitalization is larger than the net earnings of the last 12 months, which suggests the stock is overvalued (i.e., the stock is too expensive).
On the other hand, if the P/S ratio is lower than 1, it indicates the market capitalization is smaller than the net earnings. This is a great indication that the stock is undervalued (i.e., the stock is cheap). It is also one of the first things stock analysts look at when selecting stocks.
Similarly to the P/E ratio, the main purpose of the P/S ratio is to determine if a stock is overvalued or undervalued.
The dividend payout or yield is how much a company pays its shareholders for holdings a share of the company. This number is a percentage of how much a company pays its shareholders compared to how much it earns. Payout ratios range from 1% and can go as high as 6% or even more.
Some things to keep in mind: some companies may temporarily increase their annual yield to attract investors. However, this usually isn’t sustainable, and they may have to reduce them in the short term.
A good place to start looking for consistent high-dividend yielding stocks is the Vanguard High Dividend Yield Index. This index compiles stocks that have consistently increased their yield for at least five years, but most have more. Johnson & Johnson (JNJ), for example, has increased its yield every year for the last 60 years.
On the other hand, some companies in the early stages don’t pay dividends at all, instead choosing to reinvest their capital into growing. It’s crucial that you make sure the stock you choose aligns with your goals.
The Beta is a measure of how a stock, or an asset type, behaves compared to the stock market as a whole (i,e, it measures how volatile an asset is). A Beta is a number that can be calculated using regression analysis. It’s a number that ranges from -1 to 1 and indicates the performance of particular security with respect to the market.
A Beta of exactly 1 indicates a complete correlation between the security and the market; if the market has an upturn, so will the particular stock.
If the Beta is zero, that means there is no correlation between the market and the asset and that they work independently. A prime example of this is haven assets like silver and gold. These have historically retained their value regardless of what the market does.
If the Beta is negative, it indicates an inverse correlation between the market and the asset. However, if the demand increases, the asset's value decreases, and vice versa.
You should keep this in mind when building your portfolio and make sure you have a healthy mix of assets that have a positive Beta (these will make you the most profits) and investments that have a Beta close to 0 (these will add stability to your portfolio).
The next step is to build a diversified portfolio. You’ve heard this before: Don’t put all your eggs in one basket; this is remarkably accurate when it comes to investing.
If you pick and invest in just a handful of stocks, you’re adding unnecessary risk to your portfolio and setting yourself up for failure. In terms of the Beta number, if you invest exclusively in stocks with a very high correlation with the stock market (Beta=1), your holdings can be decimated in a matter of days if the market takes the smallest of downturns. The same thing happens if you invest in a single industry - any downturn will slash your profits.
The most important thing to consider when building your portfolio is to allocate your investments across different assets: stocks, bonds, real estate, commodities, and cash. With this approach, you can reduce the overall risk and cover yourself for most scenarios. It’s also important to consider industry and stock diversity. This can be achieved by investing in uncorrelated industries and by investing in both growth stocks and dividend-yielding stocks.
An IPO, in the stock world, stands for initial public offering. It happens when a company has decided to go public and offer its stock to anyone that wants to buy it. Businesses usually do this to raise funds which helps with growth. Buying it right at the start of an IPO can be a good strategy, but only if the company has good fundamentals and plans for good growth. Some companies announce IPOs months, even years in advance while others are a bit more secretive about it. For example, the Databricks IPO has been rumored for a while but there’s nothing concrete out there yet. Databricks haven’t officially laid out its IPO plans and are still private, even though there are some pre-IPO investment options out there for those interested. Buying stocks from initial public offerings can give you a more balanced portfolio, especially if you’re buying for a long-term investment.
By now, you should have a clear idea of how to pick stocks that will suit your long-term goals. Keep in mind that this process can be very time-consuming - you will need to keep up with all your supplies daily to ensure you capitalize on all the opportunities. You will also need to stay on top of news and worldwide developments that can affect the prices of your holdings.
If you don’t have that kind of time available to you at the moment, it might be worth considering a stock-picking service. These platforms offer research tools, expertly-made diversified portfolios, test environments to test strategies, and more. We review the nine best stock picking services in 2022, so make sure to check that out.