Photos provided by Carolyn Forsyth
Investing in individual stocks can be daunting and exciting to a new investor. The following guidelines can assist in building a stock portfolio.
September, 2017
THE BUY DECISION...
Determine how much you will invest.
Invest in what you know.
Research before selecting the stock you will purchase.
Set a timeline and an expected return for your investment.
THE SELL DECISION…
Understand a loss on your investment.
Taking profits.
Reinvest.
Below is a discussion of these guidelines.
THE BUY DECISION…
There are times when it seems like it would be nice to own shares of a company. Individuals can and do purchase stocks. Owning shares in a company can provide an investor with a bit more of a stake in their investments. I asked a young person who had some funds available if they wanted to invest some of their savings from an old 401(k) into a new fund or in some individual stocks. The reaction seemed appropriate “What do I know about companies?” Well, they work for a company and had a solid understanding of the general ledger, inventory and cash flow. To me, that’s enough of an education to get started. I also pointed out that mutual funds were a collection of company bonds or stocks. It’s just that you don’t get to do the picking.
Determine how much you will invest.
How much do you want to invest in individual stocks? If you’ve never done this before, start with 10% of your total savings. It doesn’t matter if it is $100 or $1,000. It’s just an amount of money that you are going to direct toward a specific target.
Invest in what you know.
Take Peter Lynch’s advice and “Invest in what you know.” That approach worked quite well for him and the purchasers of the fund he ran. He’s currently retired but he successfully ran the Fidelity Magellan Fund which had a 29% average rate of return over 20 years. No other mutual fund has ever matched that success.
How do you know what you know? I’d suggest you start with your kitchen. We buy products based on how we were raised, what meets our needs and what fulfills our desires. Advertising is all about that. When you look in your kitchen you see multiple products and choices. What pasta do you buy? Why do you buy it? Do you buy it because that’s the same pasta that your family served and it meets your expectations? What about cleaning products? What about kitchenware?
When you have a list of things you really like and that you would buy over the competitors (even when they are more expensive) you have a bit more work to do. What company makes this product? The internet makes this pretty easy but labels on packages can work as well. When you can align products to their parent company, you’ll need to know if they are publicly traded. For example, Febreze©, Gain© and Oral-B© are all brands of Proctor & Gamble (PG is the ticker symbol). It’s a publicly traded company and if those brands were on your list you know something about their products and clearly you like their products (This is not a recommendation for PG stock. I don’t own it nor have I ever owned it.).
At this point, for anyone beginning to trade in the stock market, it would be good to focus on well-known companies. While newer companies may be getting lots of play there’s always a lot of hype to get through. Sometimes that hype is just that, hype. More established companies generally have developed their products, established reasonable channels of distribution and know how to handle issues. Again, the goal here is to learn how to pick a stock and then benefit from the performance of the stock.
Research before selecting the stock you purchase.
Take the list of companies and review them on any of the available financial sites (Google and Yahoo and MSN have reasonable sites). Examine the stock’s history to see how it has been trading. 5 years of history is a lot of history. This will provide a sense of where the stock has traded and, naturally, the current price. Don’t make a judgement about the price (too cheap or too expensive). In general, markets are efficient. The price you see at any point should reflect the current realities of the economic environment within which the company operates. You can learn about stock prices and how they are determined (Graham and Dodd provide the appropriate calculations in their treatise ‘Security Analysis’). You could also take a class at a local college. An alternative is to accept that markets are efficient and greater minds (and numerous computer algorithms) are working the values second by second.
Review the opinions of analysts that will appear on the financial sites. These reviews will comment on historical performance and generally provide an expectation of where the stock might go in the next 12 months. You are looking for both good prospects and warnings. Those warnings should have already impacted the stock price just as good news will have impacted the price.
If the current price is $10 per share for the stock you like and the analysts are saying that the stock could go up to $15 or $20 then you may have a winner on your hands. The next step is to look at the last earnings report of the stock. You don’t need to read all of it but it is your money and it’s recommended that you at least look at what management is saying about their company. Earnings reports occur quarterly and companies will give very vague and general guidance on their future prospects. There are a variety of measures but they get manipulated by the accountants making it incredibly difficult to know exactly where a company stands. That’s because all public information has to be readily available to the public and company secrets (like the recipe for Coke© or how many iPhones© Apple expects to sell next quarter) are just that – company secrets. If they tell you, they have to tell everybody.
Now it’s time to select the stock that appeals to you. The stock should have the following characteristics:
1) Historical performance
2) Products that meet your needs, and
3) Generally favorable analyst ratings.
Set a timeline and an expected return for your investment.
Armed with that information, you need to decide what the stock price should be in 12 months. You should be able to see how the stock has performed over the last 12 months (or more) and you have the analyst opinions. If a mythical stock XYZ currently trades at $30 and has generally increased in value by 7% annually you should set an appropriate target for the next 12 months. Let’s say $33.00 per share is our target. That’s a 10% gain which you need to write down. Your own investment time horizon can be longer than 12 months but you should still review your purchases and reset your time horizon for the stock at least annually.
If you are investing $1,000 and the stock price is $30 per share you will place an order in your brokerage account for 33 shares (there will be a fee for the transaction so you need to have funds to cover that fee as well). Don’t worry about how many shares you purchase. You decided to invest $1,000 and the 33 shares gets you close to that investment amount.
THE SELL DECISION…
Understand a loss on your investment.
Once your purchase is complete, you need to take a moment and look at how you will approach a potential loss and potential gains on your investment. If the stock declines in price to $27 per share that’s a 10% loss if you sell your shares. A 10% loss is as likely as a 10% gain in a short time frame. This is where your judgement comes into play. Consider the general economic situation. Big surprises are rare (and they get lots of news coverage). Put the price in context of the overall market and make a decision. Either accept the loss (and start selecting from your list for a replacement) or wait out the current storm and see if the stock gets back on track. If the price is down 10% it’s probably worthwhile to set a price at which you will sell (in our example for XYZ Corp. let’s set it at $25). Make that your sell point and follow through. That limits your loss and allows you to repurpose the funds to a stock that is expected to perform better. Take the time to understand what happened and if there were warning signs you missed, make yourself aware of those for future analysis.
Taking profits.
On the other hand, let’s consider the case where 6 months after your purchase you see your stock at $35 per share. What do you do? Taking profits is as tough as taking a loss. The company may have made dramatic changes to packaging, pricing and distribution that have resulted in higher profits. Their competitor may have decided to call it quits (increasing sales opportunities and eliminating competition). The analysts may have underestimated the growth potential. All of these or many others can cause the increase. It’s important to understand why they are doing better than expected. You also need to assess the growth potential in the stock based on the new pricing.
The decision is
1) Take profits and exit the stock (sell 33 shares at $35 minus commissions and taxes)
2) Take profits and continue to hold the stock (sell 3 shares and pocket $105 minus commissions and taxes), or
3) Continue to hold the stock (you avoid commissions and taxes).
If you continue to own shares you need to reset your expected time horizon and the expected return on this investment.
Making a decision here is important. It resets your approach to the investment and allows you to be clear about where your money is invested and what you are expecting to receive from the investment. Taking profits is not bad, those funds are available to reinvest in new stocks you like or reduce credit card or mortgage debt.