How To Invest In A Stock (The Right Way)
We Discuss how to invest in a stock and give you the same checklist that professional investors follow to make investments
Why invest in a stock? Well, investing in the stock market in general can be a great way to build wealth over the long term.
However, it can also be risky and complicated, especially for those who are new to the world of investing.
As a rule of thumb, for anyone who just wants to passively invest (i.e. set it and forget it), we would advise being careful, using diversification (i.e. spread your investment’s around), and generally think about focusing more on index funds or other investments that revolved around betting on a single company. If you don’t want to trust us on that piece of advice (it’s ok, doesn’t hurt our feelings), the same point of view is expressed often by Warren Buffet.
However, if you want to learn how to invest in individual stocks (or want to get the kids learning how to do it the right way early on), it will require effort and some humility. It will also require knowing what to do and how to go about the process the right way.
With that in mind, we decided to put together a simple short checklist that most professional investors will following in one form or another as a guide.
In this quick 5 minute read, we'll discuss the following key steps to go through:
Define your time horizon
Start with (and always stick with) what you know
Learn to love reading
Come up with your valuation framework
Develop and write down your thesis
Constantly test and look back at step 5
So let’s get started!
Step 1: Define your time horizon
The first step in finding a great stock investment is to define your investing time horizon (i.e. how long do you plan to hold the stock?)
If you are investing for the short term (less than a year or two), you will need to clearly know your catalysts clearly.
What’s a catalyst, you ask? Great question! A catalyst is an event or a series of events that will trigger a significant change in the stock price. For example, if you are investing in a company that is about to release a new product, the launch of that product could be a catalyst that drives the stock price higher.
You can have one or several catalysts but if you are investing for the short term, it’s vital that you can answer why the stock you like will go higher in your selected timeframe.
If you are investing long term, catalysts are still important to know, but you can take a longer view of the company and it’s prospects because you have more time. In the example above, even if the new product does not do well, this may not change you view on the long term business and how the company will do over years.
It is worth pointing out that investing for the long term doesn’t mean you just sit there though. You need to be honest with yourself when you are wrong as well as be emotionally strong enough to withstand large short term swings in the stock market if you believe you are right (this is hard!).
Step 2: Start with (and always stick with) what you know
The second step in your stock investing checklist is crucial. Always start with (and stick with) what you know.
The reason is that investing in companies or industries you know something about can increase your odds of making a good decision.
For example, if you work in the healthcare industry, you may be more familiar with the companies in that industry than the average investor. That knowledge can give you an edge when it comes to analyzing those companies and making investment decisions.
On the flip side, if you start investing in companies you know very little about you at an immediate disadvantage. A key point to remember is that when you buy a stock you are buying it from someone who is selling. You want to be confident that you know more than the person selling it to you.
Step 3: Learn to love reading
The third step in your stock investing checklist is to read the filings and whatever else you can get your hands on to better inform you about the company.
Some key filings to read include the 10-K, 10-Q, Annual Report, and 14A (this is a shareholder proxy statement which can be crucial to learn key details such as how management is compensated).
The 10-K is a comprehensive report filed annually by a publicly traded company about its financial performance and is required by the Securities and Exchange Commission (SEC).
The 10-Q is a quarterly report that includes unaudited financial statements and management discussions.
The Annual Report provides a summary of the company's financial performance for the year and often includes a letter from the CEO or Chairman.
The 14a is a proxy statement that as noted above outlines management compensation and other important details.
The reason it is so important to know how management is compensated is it gives you an idea of targets they are looking to achieve (which may be good for the stock) and also how much of their reward is tied stock vs. cash payments (more stock rewards vs. cash would be mean they have an incentive personally to have the stock price go up, which is what you want too!).
Step 4: Come up with your valuation framework
The fourth step in your stock investing checklist is to come up with a valuation framework.
It's very important to come up with what you think the stock is worth and why because it will lead you to conclude whether a stock is undervalued, overvalued, or fairly valued. You want to invest in companies that you feel are undervalued.
Now, there are many valuation methods to choose from(we won’t discuss all of them here) but the most important thing to takeaway is that they all in one form or another try to answer the question of growth.
How much do you think the company will grow in the future? That is the key question you have to answer for yourself and is in a nutshell why stock prices go up and down each day (as people debate this question constantly).
Step 5: Develop and write down your thesis
The fifth step in your checklist once you have determined a stock is undervalued is to develop and write down your thesis (i.e. why will this stock go up?).
This is the most critical step in the process, and it requires you to put together all the analysis that you have done through the prior steps.
Your thesis should outline the reasons why you believe the stock is a good investment, including your valuation framework, the company's competitive advantages, and any catalysts that could drive the stock price higher (and / or longer term view if you are investing for the long term).
Writing it down will also keep you honest for step 6.
Step 6: Constantly test and look back at step 5
The final step in your stock investing checklist is to always refer back to your thesis.
When facts change, you need to be honest with yourself and change your mind. If the company's fundamentals deteriorate or if the stock price reaches your valuation target, you need to reassess your investment and potentially sell the stock.
On the other hand, if the company's fundamentals improve or if there are new catalysts that could drive the stock price higher, you need to be open to adjusting your investment accordingly.
Final Thoughts…
It's important to note that investing in individual stocks can be risky and requires a significant amount of research and analysis.
This quick checklist is a helpful guide for aspiring investors, but it's important to remember that investing always involves some degree of risk.
Good luck and happy investing!
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