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A brief introduction on how to pick stocks

January 10, 2010 Ward Williams

So even after reading my warning. and despite all the ease, simplicity, lower risks and very good returns of index funds, you still want to pick your own stocks, huh?  Read this first to see if you have the traits of a successful money manager.

I recommend keeping at least 75-90% of your portfolio in index funds (which Ill describe below), and only allowing yourself to pick stocks for the other 10-25%.  That way, if you lose your shirt, youll still have plenty of assets to fall back on.  Alternatively, you could designate your retirement funds as index-only, and stick to taxable accounts for any stock picks.  (I do this, since I dont want to screw up my age 60 retirement accounts (401k & Roth IRA), but am willing to take a little more risk on my early retirement accounts.)

Also, diversification (owning different stocks in different industries) helps you lower your portfolios risk.  The right index funds give you that diversification so that you dont have to worry about it as much when youre picking individual stocks.

1) Educate yourself

Peruse investing education websites like the Motley Fool (which has been going downhill for the last few years; but you can still find some good stuff on investing like this. or this .)  MoneyChimp is a great site too, with many investing (and general personal finance) calculators available.

Read superinvestor Warren Buffetts Letters to Berkshire Hathaway shareholders for free online (or consolidated in a much easier format in this book .)  The best book Ive read to get a feel for the correct general investing philosophy is Roger Lowensteins Buffett biography .  I recommend this as a must-read for any would-be investor to learn the correct investing temperment. which is just as important (if not more so) as learning how to value stocks.

Finally, read Benjamin Grahams classic The Intelligent Investor .  Graham was Buffetts teacher and, together with David Dodd, pioneered value investing with Security Analysis .

( One word of caution: if you ever come across someone touting technical analysis, otherwise known as charting, run the other way as fast as you can!  Technical Analysis is a stock picking method akin to voodoo (and just as scientific.)  It involves looking at the past patterns in past price data (random movements in the market) for a given stock.  Supposedly, patterns like head and shoulders (Im not making this up) are buy indicators, whereas the rounding top pattern is something to fear.  If you think trying to divine future stock movements from random patterns in past price data sounds crazy, youre right; dont give this garbage any space in your brain.)

2) Do your homework

Once you find a company youre interested in, start looking at their financial data and business model.  Order by mail or download their annual reports (10-Ks) and quarterly reports (10-Qs) from the Investor Relations section of their website.  Do whatever valuation techniques you like, but at a minimum compute some ratios (PE, PEG, Current, Quick, etc) and do a Discounted Cash Flow (DCF) analysis on a companys Free Cash Flow (FCF.)   Valuation matters !

3) Plan to buy and hold a company forever!

Warren Buffett is often quoted as saying his favorite holding period is forever.  What he means is that if you do a thorough job in steps 1 and 2 above, you should have found a company worth holding for a very long time.  Ideally, that great business would continue to be a profitable investment for years to come, so why wouldnt you keep the stock?  There are some legitimate reasons to sell, maybe the business has changed, or maybe you overlooked some glaring issue at the time you purchased.  Maybe the all-star CEO has left and youre not comfortable with her replacement.  Or, maybe you finally need the money.

Other than these reasons, plan on holding for a very long time.   Buy and hold investing forces you to do your research up front.  It also keeps you from trading too much, which incurs large costs and lowers returns dramatically.  Not only that, but the IRS tax code favors investors who hold their investment gains as long as possible (this last consideration doesnt matter for retirement accounts that are tax-advantaged, like 401ks or IRAs.)

4) Track your portfolios performance against an appropriate benchmark index

This is absolutely critical to knowing whether youre profitable as an investor or not (which is the whole point of putting in all the effort of picking your own stocks: beating the market!)  I recommend keeping your brokerage account that you use for individual stocks separate from the rest of your investments (like index funds, bonds or money market funds.)

After you calculate your total return, calculate what your total return wouldve been if youd made the same investments (amount and date of investment) in an index fund like the S&P 500 .  Ideally you would like as long a time period as possible, as random fluctuations in your portfolio can make you lucky (or unlucky) in the short term.  Check your portfolios return against a benchmark at least every 6 months to a year.  If you can outperform the market for 3 years or more by a 1-2% each year, youre doing well.

Its very difficult to gain the knowledge, emotional attitude and discipline to be a successful stock picker.  By using the resources about youll have a better chance than most, which still may not be enough.  Stock picking can be fun, but make sure youre giving yourself constant reality checks by measuring your entire portfolios performance against a major stock market index fund like the S&P 500.  Use a buy and hold strategy with a long-term (5+ years) holding period.  Thoroughly investigate the pros and cons of every investment before you buy.  Good luck!

Final word of caution and advice

Be brutally honest with yourself: if this all sounds like too much work, or if you know that your initial excitement to do the work will lose steam in a few months, just buy broad low-fee index funds .  Even buying the market will result in huge compound returns over time, and beats the vast majority of professional money managers, not to mention all your friends trying vainly to beat the market but failing.  Not only that, but index funds offer practically ZERO work and maintenance, allowing you to set it and forget it and get on with the rest of your life.