A Quick and Easy Way To Test If Picking Stocks Is Too Risky For You

There is a quick one-question, five-second test that I developed to help new investors know whether or not they should consider picking stocks for their own portfolio. David Muir, Photographer’s Choice RF, Getty Images

Successful investing comes down to one sentence: A great company is a terrible investment if you pay too much for it.

In truth, you can substitute company for any asset; it doesn’t matter if you are investing in bonds or investing in real estate.

The single biggest mistake I often see new investors make is not understanding what drives stock prices. When someone approaches me at a restaurant or sends me a message through the Investing for Beginners site, they sometimes ask me, how do I pick stocks? and Should I pick stocks for my own portfolio?. After nearly a decade of getting those questions, I finally developed a 5-second test that has served me very well.

Here it is: If a company is earning $1 per share, there is no dilution expected, it is growing at 3% annually and expected to do so forever (merely keeping pace with inflation, which is also 3%), and the 30-year Treasury is yielding 5%, how much should you pay for the stock?

If you can’t answer that question in under five seconds, you probably have no business picking stocks for your own portfolio. Instead, you might find a broadly diversified portfolio of low cost index funds more appropriate.

Why do I feel so strongly about this? Because over time, stock prices are driven by earnings per share and your returns are dependent upon how much you paid for each share of stock relative to those earnings. That is investing, in a nutshell. If you can’t tell me how much is a fair price for a $1 of earnings at a specific growth rate, you can’t hope to make money short of blind luck. You would be entering a game that was stacked against you and when you are dealing with retirement assets and the security of your family, that is not an intelligent course of action.

For those of you who are interested in the answer to the test, it depends on the rate of return you want. In that sense, it is a trick question. Someone experienced enough to know how to value a stock is going to know the price he should pay will depend upon the return he demands. If he wanted to earn 15% on his money, he couldn’t pay more than $8.58 for the stock. If he wanted to earn 12%, he couldn’t pay more than $11.44. If he wanted to earn 8%, he couldn’t pay more than $20.60.This goes back to the What would happen if a new, inexperienced investor bought the stock for $30 per share? The best return he could expect without a change in the growth rate is 6.43%.

The math involved in calculating intrinsic value goes far beyond the scope of Investing for Beginners. But suffice it to say, this test should serve you very, very well when you are determining how to build your portfolio.