Serious money should be seriously invested. Having a set of factors to consider when investing in stocks is part of the serious endeavor of investing. A rules-based investment approach will help you remain invested in volatile markets, control your emotions and reduce your chances of large losses. In this month’s Investor’s Edge column, I want to share with you a list of factors you should consider when evaluating stock investments.
It all starts with knowing your risk tolerance. There is no investment without risk. With frequent wide swings in stock prices, stock investments are certainly not without risk. So, consider your ability and willingness to live with the ups and downs of stocks. One way is to quantify risk. I recommend doing this by asking yourself what number you are on a risk scale of 0 to 10. With this risk scale in mind, assign a 6 to the S&P 500 – a major U.S. stock market index. Are you willing to take more risk than the “market basket”, or less? You may be a 7 or greater. You may be a 5 or less. There is no right or wrong number.
Consider time. What is your investment time horizon? Long-term? Short-term? One proven axiom is “It is time in the market, not market timing that makes successful investors.” Time is essential to recover from prolonged down markets. For example, after the Nasdaq index peaked in March of 2000, it began a long, steep fall that didn’t bottom until October of 2002. It did not climb back to its’ 2000 high until March of 2015 – a long time to wait just to get back to even.
It is also important to know your investment objectives. Consider your “why” for investing in stocks. It may be for current investment income or future financial needs such as your kid’s college or your retirement. This consideration should help you determine which stocks are most suitable for you (and which are not). You may seek high dividend stocks, or growth stocks that offer great appreciation potential and do not pay dividends.
Now, let’s talk about how to evaluate stocks you may want to invest in and what to consider before selling them. Just buy low and sell high, right? It’s not that easy. The two main schools of thought on buying and selling stocks are FUNDAMENTAL analysis and TECHNICAL analysis. While volumes have been written about these two methodologies, and I have spent decades studying them, I will try to sum them up here. First, technical analysis. Think of this stock selection technique as the study of the supply and demand for a stock. This is accomplished through the analysis of a stock chart. This picture of a stock gives you valuable insight of price and volume behavior for a stock. From analyzing the historical price and volume trends and patterns, you are able to derive a sense of the future price direction of a stock. As your “chart reading” skills improve, technical analysis will give you reliable indicators as to when to buy or sell a stock you are evaluating. Famous technician, William O’Neil once said, “The whole secret to winning and losing in the stock market is to lose the least amount possible when you’re not right.” Technical analysis helped him do that. On the other hand, there is fundamental analysis. This method of evaluating stocks takes into consideration a broad view of the financial health of a company. It is a study of financial statements such as balance sheets and income statements for the purpose of determining key ratios and metrics. The most common is the price-to-earnings ratio (P/E). I also recommend focusing on sales (revenues), return on equity and profit margins. Debt ratios should be considered. Cash flow and book value are two more fundamental criteria to consider. Earnings and dividend stability should be evaluated. The macro nature of fundamental analysis includes knowing a company’s management and awareness of competition for its product or service market share. This stock analysis approach follows the way of Warren Buffet, which is to “buy stocks at bargain-basement prices and hold them patiently.” These time-tested, proven stock selection methods have sparked many a debate as to which is better. I think the winner is both. You will find it invaluable to have a sense of supply and demand for a stock as well as to know if it is financially sound or not. You get both when blending technical and fundamental analysis when analyzing stocks. Together they will help you make prudent and timely decisions, whether you are buying or selling stocks.
I hope this helps. While the stock market offers attractive investment return potential, it is not for everyone. Know yourself. If stocks are right for you, be disciplined. Your rules-based approach will reduce the emotional swings that market moves like the current coronavirus stock market cycle can cause.
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