Choosing stocks can be as easy or complicated as you want. You could throw darts at a list of randomized stocks and pick whichever ones the darts hit. You could comb through Reddit’s Wall Street Bets community and go with whatever stocks are trending at the moment. You could invest in stocks you are already familiar with, such as Apple, Disney, or Netflix. The point is – there are countless strategies you can leverage to make money in the stock market. If you have no idea where to start, we’ll break down the stock-picking process and give a step-by-step overview of best practices.
1. Determine Your Goals
The first step in choosing stocks is to set financial goals. Of course, everyone’s end goal is to grow our net worth, but some nuances will affect our strategies. Young investors, like myself, are more focused on expanding our portfolios as much as possible over time. For me, this means making riskier investments early on (e.g. growth stocks) because I have the benefit of time to recover if I make mistakes. Older investors may focus more on wealth preservation to prepare for retirement, while some investors may prioritize developing passive income streams.
Spend some time to think about what your financial goals are. Everyone’s financial journey will be different based on what they want to achieve. There are three main goals that investors try to accomplish in the stock market:
- Wealth preservation – Investors interested in preserving capital will typically invest in value stocks or index funds like VOO and SPY, which are more stable and predictable.
- Capital appreciation – Investors interested in building and accumulating wealth focus on growth stocks, which have high expected returns and revenue potential.
- Passive income – Investors interested in getting regular income will likely invest in stocks and funds with high dividend yields.
Part of this process should include setting a budget. How much are you spending every month? How much can you set aside to invest each week or month? What is your budget for your initial investment?
Depending on how much you have available to invest, that can place limitations on your goals when you first start. For example, if you have limited capital, your primary goal may be balancing wealth preservation and building wealth. While you want to grow your initial investment as fast as possible, you also do not want to lose everything.
2. Decide What Type of Investor You Want to Be
After setting your goals, it’s time to start thinking about what type of investor you want to be. Many factors will affect how you invest, such as your time horizon, financial knowledge, personal preferences, risk tolerance, and availability. Because of time constraints, I am a long-term investor who occasionally makes swing trades.
There are two main camps of people in the stock market – active traders and passive investors. Active traders have a short timeframe when they make trades, whereas passive investors tend to hold positions long-term.
Active trading is a type of strategy where traders identify and time their positions to make profits. The main focus is to take advantage of short-term price movements, which means a trade could last a few seconds or a few days based on the setup.
There are four common types of active traders:
Scalpers move quickly in the market by finding and exploiting bid-ask spreads that result from temporary supply and demand imbalances. The focus for scalping is on stocks that are relatively liquid and don’t have sudden price movements. Out of all the types of active trading, scalping is the quickest strategy.
Day traders execute intraday trading strategies to make money off price changes in stocks. Usually, they make multiple trades in a day and do not keep any positions open overnight. The primary tool used for day trading is technical analysis, which focuses on price charts and patterns to determine entry and exit points for buying and selling stocks.
Similar to day traders, swing traders focus on identifying trends and price volatility. However, they usually hold positions anywhere from a day to a few weeks. They can also use technical and fundamental analysis simultaneously to find the best entry and exit points based on the stock price.
Unlike active traders, passive investors use a buy and hold strategy with long-term time horizons of years or decades. One of the most common forms of passive investing is to invest in mutual funds, index funds, or ETFs, particularly those that track the S&P 500. By investing in a broader market fund, you instantly diversify your portfolio without putting in the work to research individual stocks. The goal is to build wealth over time and make as few trades as possible.
Position traders are similar to swing traders in terms of identifying market direction trends. However, they usually have a longer time frame, so they are not always considered active traders. Typically, position traders hold positions anywhere from a few days to a few weeks or months based on how the trend moves. When a trend gets established, trend traders will jump in and quickly exit when it breaks.
In terms of time and effort required, passive investing can be as easy as you want. If you do not care to learn how to pick individual stocks, you can look for one or two total market or S&P 500 funds to invest your cash in. Many investors only invest in VTSAX or VOO, which are both Vanguard funds, and hold for the rest of their life. Most people will fall under this camp because active trading or handpicking stocks requires many hours of work each day or week, which most people do not have available. In the long run, the average passive investor has better performance than the vast majority of active investors, due to diversification and leaving their funds in the market for longer spans of time.
3. Conduct Due Diligence to Pick Stocks
Before you dive into picking companies to invest in, you need to do some research. The easiest and fastest way to lose everything you have is to throw all your cash into a stock or trade you don’t understand.
Two popular methodologies used in the stock market today are technical and fundamental analysis. Depending on your personal preference, you could decide to incorporate one or both styles into your investment strategy.
Technical analysis focuses on statistical trends, such as past price movement and trading volume, to identify patterns and trends. Technical analysts assume that a stock’s intrinsic value is already priced into its current stock price. So, they focus on forecasting future market prices based on statistics. Popular signals used to determine when to buy or sell stocks include support and resistance levels, candlesticks, trendlines, moving averages (MA), and momentum indicators.
Typically, technical analysis is used by short-term traders who want to make quick profits. Because the timeline is so short, the fundamentals of a company do not matter. Technical analysts do not need to understand what the companies they are trading do or the story behind them. All they need to know are the key patterns and trends.
Fundamental analysts focus on evaluating the intrinsic value of a company and its future growth potential. They do this by using data such as a company’s earnings, financial statements, leadership team, and economic and industry conditions. Investors typically use fundamental analysis to make long-term investments. However, short-term traders can also use this style to enhance returns.
Currently, I use both in my investing strategy. I use fundamental analysis to understand the products or services of the companies I’m investing in and what their stories are. However, I also use technical analysis to find good entry points and to buy any dips in stocks on my watch list.
Company Financials – Key Indicators to Pick Individual Stocks
When investors analyze a company’s fundamentals, they may make assumptions about potential revenue and profitability using different formulas and models. These are some key indicators to look out for:
Price-to-Earnings (P/E) Ratio
The P/E ratio is calculated by dividing a company’s share price by its earnings per share. Companies with high P/E ratios are either overvalued or have high growth potential. While the P/E ratio can be a good starting point in picking stocks, there is no hard rule on what is considered a good or bad ratio. It depends on the industry averages and future expectations.
A company’s EPS is calculated by dividing its profit by the number of outstanding common shares. Investors use EPS to gauge a company’s value. The higher the EPS, the more valuable the company is.
Debt-to-Equity (D/E) Ratio
The D/E ratio is used to determine how financially leveraged a company is. It is calculated by dividing a company’s total liabilities by its shareholder or stockholders’ equity.
4. Choose Your Broker
To invest in the stock market, you need to pick a brokerage firm to use. Different stock trading platforms will have various advantages and disadvantages, so make sure to do some research to find one that works best for you. A few things to consider when choosing your brokerage include commissions and fees, trustworthiness, technical tools, UI/UX, and the education sector.
Currently, I have accounts with TD Ameritrade, Fidelity, and Webull. For my Roth IRA, I use Fidelity to take advantage of their flagship funds, such as FSKAX and FZILX. These funds have low or zero expense ratios, which will save me a significant amount of money over decades. My favorite brokerage right now for my individual investment portfolio is Webull because of the amount of data I have access to. I check my stocks daily, so I like being able to look at all the charts, trading volume, real-time market orders, and news all in one place. While TD Ameritrade has a well-thought-out educational section and a solid reputation, I’m not too fond of their fees, which is why I have less cash there. I’ve also used Robinhood in the past, but I have stopped using them because of their lack of accountability and transparency during the Gamestop fiasco in early 2021.
5. Manage Your Risk
One of the most crucial steps when picking stocks is to manage your risk. Even for the safest assets, such as S&P 500 funds, there are inherent risks. The general rule of thumb I go by for all my investments is only to invest money that I am willing to lose or do not need anytime soon. I have seen some stocks in my portfolio fall more than 30-50% over a short period, which was a bummer. However, I’ve also seen some rise over 300-400%.
A way to mitigate some of these risks is to diversify your portfolio and make informed and educated decisions. The consensus is to maintain a diversified portfolio and not put all your eggs into one basket. No matter how confident we are about our investment, there is no guarantee that it will be a winning investment. I’ve invested in many losers and ended up bag holding my positions. The key is to not put too much into any single position or overleverage yourself with margin. Investing in stocks in different industries or sectors will help to maintain a balanced portfolio. Additionally, you can invest in an index fund or ETF to gain more exposure to stocks in different industries.
Investing is not something that can be done in a day or two, especially if you have lofty goals or plan on actively trading. Learning how to pick stocks takes time and effort. If you want to be an active trader, you need to build and test different trading strategies to see what works for you. If you have a long time horizon, understanding what you are investing in will help build wealth. If you plan on buying and holding companies for years or decades, you should at least understand their products or services. If you do not take the time to think through your investment decisions and make a game plan, you will burn through your cash quickly.
The Bottom Line
If you are new to the stock market, the process of picking stocks can be overwhelming and confusing. Don’t panic. Take things one step at a time. Before you get started with making trades, set some financial goals. Do some research into different investing styles and stock trading platforms. Decide how to manage your risk. Once you have all these things down, you can start with a small investment portfolio and then build from there.