Picking an investment: How to approach analyzing a stock.
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Deciding how to invest is a lot like shopping for a car, but a lot more consequential. You can start by understanding your personal needs and style. Then you can consider different models, comparing choices based on their price and potential performance. Investment decisions deserve a similar but even more robust analysis. For many, evaluating investments might not feel as natural as shopping on a car lot, especially if you’re doing it for the first time. But, by learning the basics, you can figure out what to look for, and what to potentially avoid. Here’s how to approach analyzing stocks.
1. Go in with a plan
Just as you choose a car to fit your lifestyle, investments should support your goals. Your plans will inform how long you want to keep an investment, and how much risk you’re willing to take on. Certain investment goals may remove some more volatile investments from your consideration. For instance, if you need money in the short-term (e.g., to pay off credit cards or pay tuition), investing in volatile assets might put that money at too much risk for your comfort. Stock prices can fall quickly, taking your plans for the money along with them. That said, (while past performance is no guarantee) stocks have also been one of the better opportunities to achieve growth over the long haul. Holding stocks for longer periods of time (10-plus years) generally reduces the risk of loss, which can make them helpful to hold to support long-term goals, such as a home purchase, a child’s education, caring for parents, or retirement. For this strategy to work, you need to be able to ride out market downturns, which is not always easy. Here’s how to approach analyzing stocks.
2. Know the different makes and models
Just like the various vehicles at a dealership, every stock is different. They can vary in size, purpose, and of course, price. It’s up to you whether you want a soccer mom van or a sports car—or something in between. When you look at a stock, you might consider its market cap, the sector it belongs to, and where it could fit into your portfolio. You can also consider what makes it attractive. Does the company pay dividends? Does it look poised to grow?
Here are some key filters that can help you to approach analyzing stocks, categorize stocks and size up their potential:
Size: When you go car shopping, you might think about whether you want a SUV or a sedan. Likewise, many investors think about a company’s size. One common measure of a company’s size is its market capitalization (aka “market cap”). This is the value of the company if you multiply the total number of outstanding shares by the company’s current share price. For example, if there were 30 shares in Eric’s Electronics and the market price was $4, the company would have a market cap of $120 (30 shares x $4 per share = $120 market cap).
Sector: If you divide all businesses by the type of industry they fall into, you have sectors. For example, banks are part of the financial sector, internet companies are considered information technology or communication services, drug makers fall under the healthcare sector, diaper-makers are an example of consumer staples, and so on. There are different ways of slicing it, but as a general standard, there are 11 sectors in the stock market, as defined by the Global Industry Classification Standard, a common tool used in the financial world. When evaluating a potential stock investment, it often helps to compare it to others in the same sector. Investing in many different sectors can help you diversify your portfolio, lessening the blow of weak performance in one sector with strong performance in another sector.
Style: Do you want to buy a hot, new car? Or are you happy to hunt for a ride that’s been overlooked? Style is not as much about the company, as it is about how an investor categorizes their investment. “Growth investors” might look for companies that are expanding rapidly. Oftentimes, these are companies that receive extensive media coverage and get labeled as disruptors. Meanwhile, “value investors” might look for companies they consider underpriced. Both investment styles have their benefits and risks, which is why many investors own a mix of value and growth stocks.
Dividends (or not): As a stockholder, your investment might pay off in two ways—1) The company’s stock price, so you can sell an investment for more than you paid, or 2) you collect dividends, a portion of profits which a company might pay to its shareholders. Not all companies pay dividends, but those that do typically do so on a periodic basis, often quarterly (i.e., roughly once every three months). While they’re not guaranteed and can be eliminated or reduced without notice, dividends can provide investors with another source of income.
Individual issue or fund: If you’re concerned by the pressure of picking a stock, you don’t have to pick just one. If you want, you can purchase a collection of stocks through an exchange traded fund (ETF) or mutual fund. These allow you to own many stocks at once. This can help reduce the risk of picking just one stock, providing you with some diversification. With ETFs and mutual funds, you can also find funds focused on specific sectors or risk levels.
3. Check under the hood
Buying a stock means becoming a partial owner in that company. As a shopper, you’re generally looking for one that is well-managed and profitable—and you want to pay a reasonable price. To find that information, turn to the company’s financials. Companies with publicly traded stocks make their financial information available to the Securities and Exchange Commission (SEC) and the public. This information, which you can typically find on the SEC’s EDGAR site or companies’ investor relations pages, includes annual 10-K filings, quarterly earnings reports, and other statements filed to regulators. You can usually find this information on the SEC’s EDGAR site and the company’s website (typically on an “investor relations” page). It’s also often included in stock profiles on brokerage platforms like Robinhood. Here are a few ways to interpret what’s in them.
4. Take a test drive
One great way to evaluate a stock is to watch and follow it for a period of time before becoming an investor. Data on past performance can help provide some context around the stock’s behavior, but putting yourself in the shareholder’s seat can sometimes give you a better feel for how you might handle what could be a bumpy ride. Even with taking great care to incorporate these and other considerations, you may find yourself with investment losses. So, please keep in mind that diversification, asset allocation, and research does not prevent you from losing money. Just remember, this article is how to approach analyzing stocks.
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