Stocks have long been the backbone of investment portfolios. They’re more volatile than bonds, but they have a higher average return over the long term. Over the last 20 years, Vanguard’s Total Stock Market Index Fund has averaged returns of 7.91% annually. Over that same period, their Total Bond Market Index Fund has averaged just 4.23%. You’d think that would mean everyone should learn to research and choose stock, but that’s not necessarily true.
On average, stocks generate higher returns than other assets, but discerning the winners from the losers is no small feat. Succeeding can make you rich, but failing can wipe out years of hard work in a moment. This guide will introduce you to the process of stock picking and help you figure out whether or not it’s for you.
How Professionals Research and Choose Stock
One of the best ways to learn how to do something is to mimic the people who do it professionally. Go ahead and copy Arnold Schwarzenegger’s workout routines, Gordon Ramsay’s curry recipes, and Kobe Bryant’s post-up shot (he stole it from Michael Jordan anyway). As the old saying goes, there’s no need to reinvent the wheel.
The people who professionally research and choose stock are called stock (or equity) analysts. These analysts use financial modeling and other forms of research to evaluate businesses and their stocks.
They usually specialize in a single market sector because it’s impossible to keep up with all the news, trends, and inner workings of every industry out there. They know what the great investor Warren Buffet once said. “Never invest in a business you don’t understand.” That goes for you too. If you’re going to pick stocks, make sure you have some first-hand knowledge of the underlying businesses and their industry.
There are two strategies that equity analysts use to research and choose stock. It would be best to use both, but time is a limiting factor (especially if it’s not your full-time job). Which strategy you lean toward will depend on your fundamental beliefs about the stock market. Let’s take a look.
1. Fundamental Analysis
People who prefer fundamental analysis believe there is an intrinsic value to every stock. They also believe that the stock price doesn’t always reflect that value. These investors try to find and take advantage of these discrepancies before their competitors can. They will try to buy stocks if they believe the intrinsic value is greater than the current selling price. They will sell if they believe the intrinsic value is lower than the selling price.
There are two approaches to fundamental analysis. The quantitative approach uses financial data, metrics, and valuation formulas. The qualitative approach is more about context and uses less tangible measurements. They work best when applied simultaneously, so professionals always use the two in conjunction with each other.
Quantitative tactics are technically demanding since they involve mathematics. Most professionals study for years to become competent at them, so don’t assume you can go out and do this with ease after reading this article.
Here are some examples of the quantitative measures they use:
- Price to Earnings Ratio (Stock Price/Earnings): This ratio is useful for comparing stocks. Imagine a business earns $500 million a year and has a stock price of $10. It’s probably a better deal than one that only earns $5 million a year but has a stock price of $100.
- The Price to Earnings Growth (PEG) Ratio compares the price of a stock to its past (and sometimes expected) earnings growth. A fast-growing company may trade at a higher price than a less growth-oriented company with equivalent earnings.
- Dividend Discount Model: This complex formula uses a stock’s projected future cash flows to investors (dividends) to estimate its present value. If the result is higher than the current price, it indicates buying would be a good idea.
- Debt to Equity Ratio (Debt/Equity): An overly high debt to equity ratio indicates that a company is carrying a lot of debt, which can be risky. It’s important to consider debt when comparing companies.
Professional analysts use these and dozens of other metrics, along with sophisticated financial models to calculate the intrinsic value of a company’s shares.
Qualitative tactics are more abstract but still essential. The classic areas to analyze are the quality of management, the effectiveness of the business model, the company’s competitive advantages, the growth potential of the industry, and their general corporate governance.
For example, a significant portion of Tesla’s value comes from the faith investors have in Elon Musk as CEO. If he were to step down, it would be terrible for the stock price. If someone figured out that he was about to retire before the news reached the public, they could make a ton of money off that qualitative insight.
2. Technical Analysis
People who prefer fundamental analysis believe that there are inefficiencies in the market and that they can find them faster than others.
Technical analysis is based on the opposite premise. Many analysts who prefer this approach subscribe to some form of the efficient market hypothesis. That’s the idea that the stock market is too good at reflecting relevant information for most people to beat it over the long-term by finding inaccuracies. Since everyone has access to the same information, it will generally be impossible to exploit an information advantage.
Technical analysts try to predict how stock prices are going to behave in the future based on the historical patterns in their price and volume. They use things like trends, moving averages, and the momentum of the stock to make decisions.
It can be tough to understand in the abstract, so here’s a simple example.
Understand the Psychological Aspects of Stock Investing
Stocks are also subject to mass psychology. Our natural predispositions have an undeniable effect on the behavior of the stock market. One stock goes up because people hype up the brand for some inane reason, and suddenly everyone wants to buy it. That’s particularly dangerous because humans have an inherent fear of missing out. We insist on swimming after ships that have long since sailed and chase stock prices up when there’s no tangible reason to do so.
If you’re going to pick stocks, it pays (literally) to be cautious about basing decisions on the whims of the public. The market often overextends itself, and you can’t let that push you into buying stocks that are artificially inflated.
The psychological drivers of stock movements are particularly important at times when many individual traders are active. This frequently occurs during bull markets when investors become more aggressive and more likely to trade on their own. Understanding these patterns can help you identify stocks that may be overhyped and ripe for a fall or those that have been ignored and may be undervalued.
You also need to understand your own psychology before you can effectively research and choose stock. Are you someone who will have difficulties riding out volatility? Are you the type to make decisions impulsively? When a stock tanks in price, will you get scared and try to sell? Those personality traits could be devastating to your wealth if you try to pick stocks, so don’t ignore them.
If the idea of all that extra work sounds daunting to you, that’s a good sign. When you try to copy anyone who performs something difficult at a high level, you should eventually come to appreciate the time and effort they put into their job. Realizing how much you don’t know is part of the learning process.
The truth is that it’s not realistic for most people to be able to research and choose stocks effectively after studying the process online for a few days, or even for a few months. Not only do equity analysts have more time and energy to dedicate to the problem than you do, but they also have more tools, connections, and insider knowledge. Even with all of that, they still have to specialize in a single industry to be competitive.
To put the difficulty of picking stocks into perspective, here’s a disturbing statistic for you: 82% of all professional money managers failed to outperform the market over a 15-year study period. Even with all their considerable resources, the vast majority of them can’t keep it up over the long term. Do you really think you’ll be able to fare better?
Where Stock Picking Belongs in Most Portfolios
Having read this introduction to stock picking, you’re probably wondering if you should bother to research and choose stock at all. It’s a personal question, so I’ll give you my personal opinion: Probably not.
Most people would be far better off sticking their money into a passive index fund that tracks the market and letting it sit there for a few decades. The amount of effort, skill, and luck that it would take to eke out a couple of percentage points more on your returns (especially after all the fees of active investing) just isn’t worth it. You’d probably be better off devoting your resources to increasing your income so that you could invest more money.
I’ll cite Warren Buffet once more because he’s one of the greatest investors of all time. When asked about what he wants his wife to do with their money after he passes away, he said: “Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund.”
If you want to research and choose stocks because you enjoy it, feel free. Just make sure you’re not risking your entire portfolio. Play around with five to ten percent of your funds for a few years and see how it goes.
Learn From the Experts, But Try Not to Pay Them
Learning to research and choose stocks is potentially lucrative. Naturally, there are many people out there who are trying to sell anyone who will listen to their “secrets of the industry.” They claim that they’ve figured out how to beat the system, and you can get their life-changing tips for a few dozen installments of $19.99.
Don’t fall for these scams. Educating yourself on investing is a worthy cause, but there are all kinds of people who are looking to make money off of you as you do it. Keep that in mind as you explore the resources out there, especially online.
There is no magic shortcut. If someone had a secret, they would just use it and make money in the markets, not sell it to you. Learn to research and choose stocks from the experts, but be cautious about anyone who asks for money in exchange or makes promises that are too good to be true.
Do you have any questions about researching stocks? Let us know in the comments below!