Cynics claim that investing in the stock market is no different than gambling in a casino. While there is an element of truth to that belief, sophisticated investors, like sophisticated gamblers, assess risks prior to placing any money on the table. In truth, stock market investing does not come without risk—but education can separate those who succeed in the market from those who fall short. There are literally thousands of stocks from which to choose, but before you take the plunge, you need to focus your time and energy on two key learning targets. The place to begin is not in the library or on the financial websites that clutter the Internet. The place to begin is in the mirror.

Know Yourself

Shakespeare said it best: “To thine own self be true.” In the excitement that often accompanies the decision to get into the stock market, investors can fool themselves into thinking they have the time to devote to staying informed about their investments. If the cold hard answer to the time question is, “No, I don’t have the time,” you would be better off dealing with mutual or exchange traded funds.

By far the most crucial question you need to address is how you feel about losing money. Obviously, you’re not entering the market to lose money, but market psychologists are now telling us that the pain an investor experiences from a loss far outweighs the pleasure experienced from a gain. If you’re one of life’s “worrywarts,” you must decide if you’re prepared to lose sleep at night if the stocks you choose fall below the prices you paid.

There’s an intellectual basis for addressing the issue of losing money, as well as an emotional basis. Here are the two rules of investing that Warren Buffet, one of history’s great investors, offers as advice:

·        Rule #1: Never lose money.

·        Rule #2: Never forget Rule #1.

Knowing yourself should have a significant impact on your stock selection. If you’re a conservative investor due to your age or temperament, starting out with lower-risk blue-chip stocks may be the way to go. Younger investors, and those for whom the ups and downs of stock prices are less intimidating, might opt to go with smaller, less-mature companies. Companies have life cycles, and newer entries to a stock exchange are more likely to post impressive gains in share price than are established companies like British Petroleum. In addition, larger companies have more liquidity and lower risk of bankruptcy.

Successful investors match their investment decisions to their own personal capabilities, including time available for monitoring investments and attitudes towards the inherent risk of losing money in the stock market.

Know the Market

You don’t have to be a certified financial analyst to be a successful investor, but the more you know about how markets work, the better off you will be. Learning is a lifelong process for investors. While the Internet has supplanted the public library as the place to begin your learning, there is one caveat all investors need to know in regards to what they read on the net. Much of what you find there is written by people with a vested interest in the movement of the price of specific stocks. This is not to imply malicious intent, but if you have “shorted” a stock in the hopes that the price will go down, what you write might emphasize the negative, while the opposite is equally true if you hope the stock price will go up.

The library may have gone out of fashion as a source, but serious investors are avid readers of the classic investment books of our time. While The Intelligent Investor, by Benjamin Graham, might seem dry to many, a more down-to-earth style can be found in the works of investor Peter Lynch, such as Beating the Street and One Up on Wall Street.

There are sites like ours that offer articles about different facets of market investing. Read as many as you can. Somewhere along the way you’re likely to learn a truism about successful investors—they read a lot!

Reading financial news and classic investing books are essential for successful investing. The more you know about stock markets and how they work, the more successful you will be at investing.

Investing Strategies

In many ways, investing strategies are grounded in how an investor feels about losing money. Over time, you will find that many investors operate with a variety of hybrid investing strategies that combine elements of the two most common “pure” strategies—Value Investing and Growth Investing.

You can think of value investors as bargain hunters. They scout for stocks whose share prices are below what they believe to be the fundamental value of the companies. In addition, they look for a margin of safety—which is a percentage difference between the current share price and the company’s fundamental value. The percentage varies depending on the investor’s risk profile, which is the amount the investor can afford to lose.

Growth investors are more concerned about a company’s future potential than its current value. They scour the market for companies, usually younger companies, with above-average future growth rates. A purist growth investor doesn’t mind paying what appears to be a high price for the stock in the belief that the stock price will rise as future potential becomes reality.

In theory, value investing has the seductive quality of buying something at a low price that will rise as other investors begin to recognize the true value of the company. In practice, the major problem with value investing is determining a company’s fundamental value, which can involve complex calculations beyond the capabilities of many retail investors.

In theory, growth investing has the seductive quality of latching onto a company with outstanding growth potential, and the possibility that no matter how high the price you pay for the shares now, you will be rewarded as the price continues to climb as the company continues to fulfill its growth potential. In practice, many growth stocks attract investors like bees to honey—investors who will begin to flee in droves should the smell of success begin to fade.

Investors adopt investing strategies that best match their personal characteristics and capabilities—principally time allowance and risk tolerance. Two of the most popular strategies are Value Investing—searching for “bargain” stocks priced below their true value or worth—and Growth Investing—looking for stocks with outstanding future growth prospects.

Stock Selection—Top-Down versus Bottom-Up

Once you’re armed with some knowledge about the markets, classic investing strategies, and yourself, you have two starting points for choosing stocks.

The first is called Top-Down Investing. Think of this as a “big picture” approach that looks first at broad economic areas that are doing well (or not doing well, if you’re interested in shorting stocks). At this point, specific companies are irrelevant, as investors break down a broad starting point into more specifics—such as starting with a national economy and then focusing on strong or weak sectors within. From the sector level, the search begins for specific industrial classifications and then stocks within the industry. Some investors begin with the list of stocks included in a mutual traded fund or exchange traded fund that is performing well (or poorly, if you’re looking for shorting prospects).

The second starting point is called Bottom-Up Investing. This approach begins with individual companies, with the assumption that there will always be stocks that outperform or underperform the sectors and industry sub-classifications in which they operate. Common sources for a bottom-up investor include the kinds of news items you find on financial websites, ranging from analyst upgrades to earnings releases, and so on.

There is another maxim regarding stock selection that can apply regardless of starting point, and that is to Trade What You Know. The idea is if you work for a retailer or have a solid base of experience with retailing, you’re in a better position to understand and analyze retail stocks. Warren Buffet supposedly responded to a question posed back in 1998 about why he was not investing in technology stocks with the reply: “technology is something we don’t understand, so we don’t invest in it.” The key word here is “understand.” For example, you may not currently “know” much about biotechnology stocks, but with time and effort you can learn enough to understand how these companies make money and the drivers of their stock prices.

The Top-Down approach to choosing a stock begins with a broad economic picture, narrowing it down to sectors of interest and then industry classifications that are performing well or poorly, depending on your preference for stocks that will appreciate in value, or for stocks that could depreciate that you can short. Bottom-Up investors go directly to individual stocks without concern for overall industry or sector performance.

In-Depth Analysis

A hard truth some investors forget is that choosing a stock without in-depth analysis is, in actuality, little more than gambling. There are two broad approaches to stock analysis, and many investors combine elements of both. The first approach is Fundamental Analysis.

Fundamental Analysis involves both the quantitative analysis of issues you find on a company’s financial statements as well as the qualitative analysis of less tangible issues, such as the business model, company management, competitive advantage, market share, and customer base.

Part of your efforts to learn the market needs to include the basics of financial ratios that investors use to value stocks. There are a wide variety of ratios available, most calculated from readily available information in company financial statements. Financial websites spare you the calculation time by providing values for the most widely used ratios.

Technical Analysis involves a complex set of tools used to predict future stock price performance based on historical information primarily focused on price and volume of trading. Sophisticated technical analysis tools are often beyond the reach of most beginning investors, but there are some basic measures—like moving averages and relative strength—that are easier to learn and track.

The type of in-depth analysis used is seen by some as a marker that differentiates investors from traders. Hard-core technical analysts are little concerned with fundamentals because short-term trading gains are paramount. Investors have a longer time horizon and thus should be more concerned with fundamental valuation measures.

Fundamental Analysis and Technical Analysis are two approaches used for in-depth analysis of a stock. Fundamental Analysis is quantitative (focusing on financials) and qualitative (focusing on intangibles like management, market share, and competition). Technical Analysis relies on past history of a stock’s price performance and trading volume.

Investment Thesis

Once you’ve done your initial homework on a prospective investment, an essential final step is to commit in writing your Investment Thesis, or simply a statement of why you’re buying the stock. It can be helpful to first verbally explain your reasoning to someone who has a critical eye and is not afraid to challenge your thinking. This statement is an essential tool for monitoring your stock’s performance over time. Changes in your Investment Thesis can be a signal to reconsider your position in the stock. Positive changes could lead to buying more, while changes that are less than positive could mean holding, reducing the amount you own, or selling out entirely.

An Investment Thesis is a written statement that outlines the reasons you’re buying a particular stock. It serves as a yardstick to monitor the stock over time.

Bottom Line

The process of choosing a stock begins with a personal assessment of capabilities and risk tolerance, and an investment of time and effort in learning some market basics. The strategies that investors use to guide investment decisions generally follow from these factors and include value investing and growth investing—and often a combination of elements of both. Value investing focuses on stocks priced below what they are fundamentally worth, while growth investing looks for stocks with bright future prospects.

Investors begin their searches from the top down or the bottom up, with the former beginning with “big picture” issues and the later focusing on individual companies. Once a potential target is identified, the prospect needs to be analyzed, using fundamental quantitative and qualitative analyses, and in some cases, technical analysis of historical price trends. An investor should prepare a written statement spelling out his or her rationale for the investment decision, which then becomes a monitoring tool in the future.

Summary:

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Successful investors match their investment decisions to their own personal capabilities, including time available for monitoring investments and attitudes towards the inherent risk of losing money in the stock market.

 

P

Reading financial news and classic investing books are essential for successful investing. The more you know about stock markets and how they work, the more successful you will be at investing.

 

P

Investors adopt investing strategies that best match their personal characteristics and capabilities—principally time allowance and risk tolerance. Two of the most popular strategies are Value Investing—searching for “bargain” stocks priced below their true value or worth—and Growth Investing—looking for stocks with outstanding future growth prospects.

 

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The Top-Down approach to choosing a stock begins with a broad economic picture, narrowing it down to sectors of interest and then industry classifications that are performing well or poorly, depending on your preference for stocks that will appreciate in value, or for stocks that could depreciate that you can short. Bottom-Up investors go directly to individual stocks without concern for overall industry or sector performance.

 

P

Fundamental Analysis and Technical Analysis are two approaches used for in-depth analysis of a stock. Fundamental Analysis is quantitative (focusing on financials) and qualitative (focusing on intangibles like management, market share, and competition). Technical Analysis relies on past history of a stock’s price performance and trading volume.

 

P

An Investment Thesis is a written statement that outlines the reasons you’re buying a particular stock. It serves as a yardstick to monitor the stock over time.

 

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