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Stock Picking can seem like it can be a very complicated process. Investors from all over the world will have very different approaches. However, following 3 simple steps can help you develop a plan which can greatly improve your chances of picking profitable stocks.
Step 1. Time
How long will you be investing for? This is an extremely important question because it can shape the type of stocks that you wish to buy.
Short term Investor
Suppose you are a short term investor who wants to “invest” for a couple of years or even days. There a couple of strategies that you might like to take. For example
You might look for stocks that have increased in both price and volume over the recent past. If the stock is in a clear uptrend, you simply ride the trend until the trend breaks. This is called momentum trading and is a very popular strategy amongst traders who are investing for the short term.
The Trend is your Friend except at the end when it bends
Ed seykota
Another popular short term strategy is when you take advantage of an over reaction in the stock market. Sometimes when there is bad news about a company,people will panic and the price often drops below the companies fair value. for example if the stock drops 20% after the company loses a legal case that has no permanent damage to the business’s brand and product, you can be confident that the market over-reacted.
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Long Term Investor
Truth be told, I believe short term investing is more akin to gambling than investing.I have included it because it is an approach that people like to take.
Those of you who have read my blog before will know that I am very much a long term investor.
Time in the market is more important than Timing the market
Charlie Munger
The trick to long term investing is to find companies who have a sustainable competitive advantage that show positive signs of stable growth. Think of companies over the last number of decades who have stood the test of time. Research what they have in common and why they lasted so long. Complete a simple business S.W.O.T. (Strength-weakness-opportunity-threat) analysis on the company and decide if you believe the company will still be around in 20 years time.
You can read my Blog Post here about some of the metrics that I use to pick companies to invest in.
Step 2. Research
Research, Research and Research some more. We live in a generation where we have more information at our fingertips than we know what to do with it. Websites like the list below are just a couple of examples where you can find more information on the companies you would like to invest in.
I also read a ton of articles and blogs. For Blogs that I like to read,please check out my blogroll and if you have an interesting blog, please let me know in the comments and I will add you to the list
Step 3. Diversify
The most common interpretation of the term diversification is that investing is spread across a broad range of markets. This in essence is one of the most effective ways of reducing risk.
Markowitz Theory
To reduce risk, you need to understand what level of risk you are undertaking and how to measure this risk in you portfolio. Harry M. Markowitz developed a framework for analysing the risk and return of your portfolio along with their inner relationships. His theory relies heavily on standard deviation to determine the deviation of the returns and correlation coefficient of the proportion of companies in your portfolio.
The parameters he requires for building up a portfolio include:
- The Expected Return
- Variability of returns as measured by standard deviation from the mean
- Co-variance of one asset return to other asset returns.
Once you have a list of stocks to buy, you would need to diversify them in a way that gives the greatest reward/risk ratio. One way to do this is conduct a Markowitz analysis for your portfolio. The analysis will give you the proportions of money you should allocate to each stock.
Luckily you do not have to be a sort of math guru to work this out as their are plenty of resources out there that can help you, like this excel spreadsheet from finance toys.
In my own portfolio, I try and diversify not only across different sectors but also companies within different sectors.
These three steps should help you pick profitable companies to invest in. It will also help you learn about the the financial markets and hopefully give you some confidence in making better investment choices.
Disclaimer - Engineer my Freedom is not a licensed or registered investment adviser or broker/dealer. We are not providing you with individual investment advice on this site. Please consult with a licensed investment professional before you invest your money. This site is for entertainment, informational, and educational use only. Any opinion expressed on the site here and elsewhere on the internet is not a form of investment advice provided to you. We use information, data, and sources in the articles we believe to be correct at the time of writing them, but there is no guarantee of their accuracy, completeness, timeliness, or correctness. We are not liable for any losses suffered by any party because of information published on this site or elsewhere on the internet. Past performance is not a guarantee of future performance. By reading this site or subscribing to it, you agree that you are solely responsible for making investment decisions in connection with your funds.
Nice post! I’ll point out that what you’ve done is list three strategies in order from most risky to least risky. Momentum trading is riskiest, the second one you mentioned seems to describe an event-based strategy (medium risk) while the third, and my most preferable strategy as well, is long-term investing.
Nice that you mentioned Markowitz modeling – I actually wrote a series of posts detailing how I go about building portfolios, and a sample model is included. It’s a big part of my strategy so I’ve become pretty good at maximizing Sharpe ratios, but like any models it requires good data to avoid GIBO (garbage in, garbage out). Still, even if it’s not your strategy, I believe it’s worthwhile running your portfolio through a Markowitz model to see if the expected risk corresponds to your desired risk.
Would you believe those strategies where what I have tried to use, in the exact order that I wrote. I used to think I was a bit of a risk taker but in actual fact I feel much better with the long term approach than I ever did trying to trade the markets in the short term. When trading momentum for example, not only was I losing more money but I always felt anxious when I had money in the market. Knowing now that I have a long term plan, i feel alot more comfortable with the fact that I might make mistakes along the way but I am constantly learning and if I keep learning I can make a decent retirement fund for my family.
The Markowitz modelling was a new concept to be up until recently and as I am a little bit of a nerd, I want to study it a bit more in dept and the actual mathematics behind it.I noticed that you have a template for building an entity model on your website here. I just have had a quick look at your “building a bulletproof 2020 portfolio” series and it looks impressive. I have bookmarked it for in dept reading over the weekend and I cant wait to play around with the excel template
Thanks very much for taking the time to comment. It is much appreciated.
I truly believe in lowering volatility to improve returns. Google the Low Beta Anomaly and you can read a great paper discussing how such stocks, commonly referred to as defensive stocks, significantly outperform high volatile stocks. I noticed it a few years ago in my analysis of Canadian stocks and came across the paper after, and it proved to be a great confirmation for me. It’s why the Markowitz model is of great use, but again you have to use the right inputs. I’ve lengthened my analysis period and its improved my returns significantly.
Thanks for checking out my series of articles. If you need additional data, such as monthly returns for Canadian stocks, let me know. I have many U.S. monthly returns too, just not verified with the same level of scrutiny. Unless you’re willing to pay a pretty penny to Reuters or Bloomberg for such data, it was the best I could do. Good luck!