Stock picking is a very complicated process, and investors have different approaches. However, it is wise to follow general steps to minimize the risk of investments. This post will outline these basic steps for picking high-performance stocks.
Step 1. Decide on the time frame and the general strategy of the investment. This step is very important because it will dictate the type of stocks you buy.
Suppose you decide to be a long-term investor. You would want to find stocks with sustainable competitive advantages and stable growth. The key to finding these stocks is by looking at the historical performance of each stock over the past decades and doing a simple business S.W.O.T. (Strength-weakness-opportunity-threat) analysis on the company.
If you decide to be a short-term investor, you would like to adhere to one of the following strategies:
Momentum Trading. This strategy is to look for stocks that have increased in both price and volume over the recent past. Most technical analyses support this trading strategy. My advice on this strategy is to look for stocks that have demonstrated stable and smooth price rises. The idea is that when the stocks are not volatile, you can ride the uptrend until the trend breaks.
Contrarian Strategy. This strategy is to look for overreactions in the stock market. Research shows that the stock market is only sometimes efficient, which means prices only sometimes accurately represent the values of the stocks. When a company announces bad news, people panic, and the price often drops below the stock’s fair value. To decide whether a stock overreacted to news, you should look at the possibility of recovery from the impact of the bad news. For example, suppose the stock drops 20% after the company loses a legal case that has no permanent damage to the business’s brand and product. In that case, you can be confident that the market overreacted. My advice on this strategy is to find a list of stocks with recent price drops and analyze the potential for a reversal (through candlestick analysis). If the stocks demonstrate candlestick reversal patterns, I will go through the recent news to analyze the causes of the recent price drops to determine the existence of oversold opportunities. This step may also be very effective for a long-term strategy as well. Buying good companies on the bad news that causes the stock to pull back but does not have a long-term effect is always a good long-term strategy.
Step 2. Conduct research that gives you a selection of stocks consistent with your investment time frame and strategy. Numerous stock screeners on the web can help you find stocks according to your needs.
Step 3. 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 to conduct a Markowitz analysis for your portfolio. The analysis will give you the proportions of money you should allocate to each stock. This step is crucial because diversification is one of the free lunches in the investment world.
These three steps should start your quest to consistently make money in the stock market. They will deepen your knowledge about the financial markets and provide confidence that helps you make better trading decisions.
While I do not advocate short-term investing or trading, I firmly believe in a well-planned long-term strategy. If you need assistance with developing a long-term investment plan or financial planning in general and live in the metro-Nashville area, contact me directly. For those outside middle Tennessee, seek a qualified fee-only Registered Financial Consultant (RFC) near you.
