Stock market investing is safer than bank deposits. Quite shocking, isn’t it?

The principal trick is to choose the right company to invest in. Understanding finances or reading company reports will help. All it takes is a little bit of arithmetic and few hours a week. There are three basic questions to keep in m ind.

Why should I invest?

Everyday products are churned out by public companies. Why not let your money grow with them? One needs to invest in the stock market to beat inflation. The average inflation rate is 6%. Your investments in banks automatically lose around 9% due to inflation and taxes.

How should I invest ?

 1)  Make a list of all the essential criteria that a company must meet. Invest only if it meets them. Some of the most important criteria to look for: consistent earnings, no debt or very low debt, substantial cash flow, good margins and a great return on capital.

2) Invest at the right price. It is as important as investing in the right company.

3) Scrutinize company reports to detect accounting scams. Here are two warning signs.

a) Company A is not able to make money, but doesn’t want its share price to go down. What does it do? Manipulate its accounting. How? If it has made a sale, but not yet collected money from the customer, the sale can still be included in its yearly sales. How can an investor detect this? By watching out for accounts receivables. If accounts receivable is more than 10% of total sales, then it is a clear warning sign that the company is into some scheme to generate income. No corporation pays a bill the instant it arrives. It takes anywhere between 45 days to 60 days for pending bills to clear. But if a company’s accounts receivable extend beyond that period, it is a clear warning sign.

b) Even corporations, like individuals, need to pay taxes. If a company has good earnings and sales, but is not paying little or no taxes, it’s a red flag.

Where to invest

Consider parking your investments in Roth IRA, education IRAs, Coverdell ESA and 529 plans. They offer tremendous tax benefits.

Debunking Myths

Myth: Assumption that as soon as you buy a stock, it’ll go up.

Fact: Small lots of shares being bought by an individual cannot make a dent in share prices. Institutional investors mainly drive share prices. Major institutions such as Vanguard, Fidelity, etc. buy millions of shares at periodical intervals. That’s when the share price goes up. Similarly, when they start selling, they sell in large quantities and thus the price of a stock crashes.  So an individual investor who wants to profit from the stocks has to enter before major institutions start buying the stock and exit before they start selling.

Myth: An analyst can always predict whether a stock is likely to go up or not.

Fact: An analyst’s job is to report the future of the company. He upgrades a stock after it has reached its peak price and downgrades after it drops. Mutual fund managers look at various aspects before pumping in more money into the stock and one such factor is the analysts’ recommendation. However, an individual investor cannot profit from the analysts’ recommendation as there are too many analysts recommending individual stocks and an individual investor cannot sort through all the recommendations of analysts.

Myth: Diversification avoids risks

Fact: There is no difference in the risk levels between investing in diversified stocks and individual stocks. If investors want to profit from the stock market, they can do so by simply analyzing few companies that they are comfortable with instead of following the entire market.

Bottom line

One can invest profitably in the stock market. All it requires is basic financial knowledge. Resources are available in plenty. So do your homework and invest like a pro.

Siva Nara and Priya Raghavan are coauthors of Dollar Wise, Penny Foolish?