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New investors are interested in buying the individual stocks of a company, but they are not sure whether it will be a good asset in their portfolio or not. But many factors can help you decide the better options and weed out the ones that may not be appropriate for you. A lot depends on your risk tolerance and how long you plan to own the stock to the company’s value. Here’s what you need to look for to choose the best stocks for your portfolio.
In this article
Your time horizon
You must have a time horizon associated with the investment. It will play a huge role in whether the investment makes sense for your situation. The time horizons can be broken down into short-term, medium-term and long-term.
Short-term investing
When you plan on holding the investment for less than one year, it is a short-term time horizon. Investments with a short time horizon have less time for recovery if something goes wrong. It is best to invest in blue-chip stocks if your investment period is short and choose stocks that pay dividends. Such companies have solid balance sheets and make the risk minimal. However, the gains will be slow.
Medium-term investing
A medium-term investment is one where you hold it anywhere from one year to 10 years. Since it has a longer time horizon, there will be more time for recovery when something goes wrong. You can invest in emerging market stocks to enjoy a moderate level of risk and generate income in the form of capital gains.
Long-term investing
Lastly, the long-term investment is the one you plan to hold for more than 10 years, and they have maximum recovery time when something goes wrong. You can choose ideal stocks for your investment portfolio and allow diversification. It has the least risk and a solid chance to generate strong returns.
Related: How to Pick Stocks: A Beginner's Guide
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The investment strategy
It is essential to understand different investing strategies and choose the one you will follow. This is important because many people make decisions based on emotions and guesswork, leading to a loss. When you have an investment strategy, guesswork is out of the question, and you have a strict guideline to follow when it comes to buying and selling stocks. Choose a strategy and ensure you buy stocks based on the same. There are three types of methods you can consider:
Value investing
Value investing is a process where you invest in undervalued stocks as compared to your peers in the hope of generating outsize gains once the market catches on to the opportunity. Warren Buffett has made millions with this strategy.
Growth investing
Another strategy is growth investing, which is choosing stocks that show market-beating growth in earnings, revenue, and capital appreciation for a long time. Investors who think that this trend will continue will choose this strategy, creating a chance to outsize gains.
Income investing
Income investors look out for growth stocks that pay dividends. It helps generate passive income and allows dividend reinvestment to increase the income.
Hence, before you dive into a stock investment, it is vital to consider the strategy you have chosen and whether the stock you want to invest in fits in well with this strategy.
Common stock or preferred stock
Companies issue two types of stocks, common stock and preferred stock. A lot depends on the kind of stock you buy, and it will have an impact on the earnings potential and the ability to minimize the losses. The common stock is a standard type of stock that most investors buy. When the dividends are declared, these shareholders will be paid dividends, and they have a claim on the company's assets in case of liquidation.
Another option is the preferred stock which puts the investor up the ladder. It comes with predetermined dividends that are regularly paid and paid before the common stock dividends. They also have a claim to the company's assets in case of liquidation and will be paid before the common stockholders. Hence, the preferred stockholders have low risk and a high chance of generating income when it comes to risk.
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Volatility
One aspect of a stock market investment is volatility, and it shows the rate of fluctuations in the stock price. When there is high volatility, the stock price will rise and fall faster, and if there is low volatility, the asset will move steadily. You must remember that volatility is a part of the investment journey and is not always a bad sign. Volatility is the rate of fluctuations in the movement of the stock, but it does not determine the direction of the movement.
The stocks with high volatility will climb high on good days and fall significantly lower on bad days. Hence, the investments come with more risk than stocks that do not move fast. If you invest in a low volatility stock, it will have lower risk, and when the uptrend begins, you will have enough time to cash in on the profits. In contrast, the stocks that experience high volatility will give you more time to exit the investment when the trend reverses, and it could lead to losses.
Reasons for buying a stock
The company’s value
It is important to look at more than just the current stock price while doing your research. You need to check out the entire value of the company. The cost of a company is known as market capitalization or market cap. This is the total value of the company’s outstanding stock shares, which includes the restricted shares held by the company. To know the enterprise value of the corporation, multiply the number of shares by the current stock price. When you add debt to it, you will get the enterprise value. The market cap is the price of all the outstanding shares of the stock that is multiplied by the market price of the share at the given moment in time. If a business with a million shares outstanding and the stock price is $50 a share, its market cap will be $50 million.
When you understand the company's market cap, you do not overpay for the stock. Two different companies can have a different market cap, but the stock price could be the same, which makes all the difference. It is unbelievable that an investor will have to pay the same amount for a company that is making $4 billion net profit and one that is making $48 billion net profit.
Price-to-earnings ratio
A very useful tool that helps estimate the relative cost of the stock is the price-to-earnings ratio. It can be calculated by dividing the price per share by the per-share earnings. It helps with the standard comparison for alternative investment opportunities. If the stock value is $20 per share and it has an annual net income of $2 per share, then the P/E ratio will be 10. Shares with a higher P/E ratio are expensive, while those with a lower P/E ratio are cheaper. The P/E ratio also helps determine if the stock is overvalued or undervalued. Compare the P/E ratio of the company with the industry average and then make a decision.
Stock buyback
An important aspect to understand is the per-share growth. This is more important than the overall growth of the company. A company can have the same revenue, profit, and sales for two years in a row, but it can create returns for the investors by reducing the number of outstanding shares. Whenever the company reduces the total number of shares, it will make your stake in the company larger and benefit you in the long term.
Dividend yield
An obvious metric to look at when choosing stocks is the dividend yield. It will tell you how much you can expect from the company for every dollar you invest in it. Check the dividend growth rate as well. It is the rate you can expect the dividend income to grow each year. High yields mean a high dividend payout and you will earn more on the investment.
Company fundamentals
An important aspect to look at is the company’s fundamentals. You can get more details about the same by checking the quarterly and annual reports published by the company. It will have the details of the company’s earnings, revenue, net income, earnings per share, and dividends. This will help understand the company's market value and you will be able to decide if the profits are stable or volatile.
Debt-to-equity ratio
The debt-to-equity ratio is a metric used by investors to estimate how thin the company has stretched itself in terms of debt. With a high level of debt, the chances of bankruptcy are possible. You need to divide the company's total debt with the shareholder equity to find the debt-to-equity ratio.
When the ratio is high, the company has leveraged debt. You must buy stocks in companies that do not leverage debt too much, which means you will be best served in companies with a low debt-to-equity ratio. A ratio below 1 is a low-risk investment, and one above 2 means the company has debt and a high level of risk.
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The bottom line
A serious mistake that beginners make when it comes to investing is buying stocks because they know the company's name or someone told them to buy them. However, such actions will lead to a rise in the chances of losses and will decline the profitability potential.
If you are keen on buying stocks, you must educate yourself about the market, stock, and the economy before pulling the trigger on the purchase. When you research well, you will make a solid investment decision.
Once you decide to take the step ahead, you will have to open a brokerage account and consider its cost. Many online brokers offer zero-commission stock trading like Robinhood. Some also provide investment advice and allow you to invest in mutual funds, index funds, and ETFs, making it easier to achieve your investment goals. If you have no idea how to get started and are scared of leaping, you can consider a robo-advisor like Wealthfront for better stock picking.
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Editor
Vandita Jadeja is a financial writer and editor at Joywallet. She loves to read and write about money and brings a decade of experience from the financial industry.
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