Building an investment portfolio: the art of picking stocks
Investing in stocks and shares is an enticing prospect for anyone wanting to grow their money. Historical returns from the stock market have outperformed cash over longer timeframes, and there are currently paltry returns on cash deposits. So, how do you pick those winning shares that will increase your wealth over time?
There’s no one-size-fits-all approach to building an investment portfolio of stocks. It will depend on whether you want to grow your capital or earn income from your capital, your attitude to risk, and how much time and effort you are willing to put in. However, there are a few basic principles of stock picking which can boost your chances of success.
Do your research
While there isn’t a magic formula for successful stock selection, many people use some form of fundamental analysis, looking at the key numbers from company accounts and reports to analyse the health of a business. This will help you make a judgement as to whether a stock looks cheap relative to its profitability and potential.
Stock pickers will look at net profit (what’s left over when expenses are subtracted from revenue), revenue growth, price-to-earnings ratios (how much the investors pay for every pound a company earns), how much debt a company has, free cash flow (how much cash it generates after capital expenditure on buildings or equipment), and whether it pays a dividend to shareholders or reinvests its cash into growing the business.
Learn more about what the FTSE 100 P/E ratio is and whether it really matters
Short-term traders may use technical analysis to pick stocks, charting share price movement over time.
Understand the business
You will need to look at the company in the context of its sector and the wider economy to really understand its prospects. What does it sell and who are its customers? Will they still want and be able to afford its products two, five or ten years from now? How will it stay ahead of its competitors? How would it be affected by an economic slowdown or rising interest rates?
If you don’t understand how a company makes money, you shouldn’t own it. This is why many investors start out by holding shares in familiar brands with straightforward business models: high street retail chains, fashion brands or tech giants, for example.
Read more in this series, ten things you need to know when building an investment portfolio
Quantitative and qualitative appraisal
Stock picking is both art and science, so intuition and experience are as important as crunching the numbers. You will learn a lot from tracking your most successful stock picks, and perhaps more so from those that don’t turn out as you had hoped. Fund managers do a mixture of quantitative and qualitative analysis to build their portfolios, including face-to-face meetings with the management of companies whose stocks they hold.
While reading the annual report and stockbroker research notes can get you so far, fund managers often say there’s no substitute for looking the CEO in the eye and hearing what they have to say about their company’s performance and plans. For most DIY investors, this will not be an option, but it does demonstrate that you might want to look beyond the numbers on the balance sheet and think more intuitively about stocks. Look for executive presentations on the company website or online and get a better feel for the people running the company and their vision for the future.
Don’t be driven by emotion when choosing shares
You don’t want emotion driving your investment decisions. The old adage says that fear and greed drive market movements, but you can avoid running with the herd if you remove emotion from the equation. This means you will avoid buying shares in a company you may not fully understand just because of the hype around it, and, if your stocks fall, you will hold your nerve and buy more at discount instead of rushing to sell out in fear.
Stocks can be volatile so be prepared for a bumpy ride: have a look at the 52-week high and low of a particular stock to get a feel for the potential price swings.
Read more: time in the market or timing the market?
Cheap stocks are good, but always be wary
Be wary of focusing solely on the price as a signal to buy stocks. Just because something is perceived as cheap, doesn’t mean it’s a good deal. Shares are usually cheap for a reason, so try to work out what that reason is.
If it’s a turnaround story or a case of the market not recognising a business’s real potential, that is a much more compelling case to buy it than if the business is poorly run, indebted or unprofitable.
One of the key rules of stock picking is to make sure you build a portfolio to spread your risk. If you are invested in one or a few stocks, you are at the mercy of fluctuations in individual stock prices. If your stocks are concentrated in too few sectors, you will suffer when that sector goes through an economic downturn. By diversifying, you spread the risk because it is more likely that when one company or sector is suffering, others are thriving.
Learn more about the power of diversification
Learn to know when to sell
Although you may consider yourself a long-term investor (and this is a good strategy when it comes to stocks), you’ll still need to know when is the right time to sell.
You might decide to take profits when a stock climbs to a certain price target, or sell out when it falls below a certain floor. Or perhaps if the company cuts its dividend or changes its strategy, it no longer fits the investment case that originally attracted you. This is your sell discipline, and is just as important as the decisions you make when buying stocks.