Most ill-equipped for stock picking
It's exciting, particularly when it works out well. It has status because it 's associated with high finance. But it's not for everybody and may have more sizzle than steak. I'm talking about individuals picking their own stocks. It has natural appeal, and really caught on a few years ago, but there are good reasons why most individual investors have no business picking their own stocks.
At the heart of my opinion on this issue is that fact that most people don't have a disciplined process in place (or ability) to evaluate stocks, let alone actually quantifying a value for them. In other words, if you can't articulate what a particular stock is worth and why, you have no business trading in the stock.
Let's say you buy a stock and it goes up. How do you decide when and at what point to sell? If you have no reference point (i.e. valuation) then selling is like walking through the streets blindfolded. You're taking a big gamble and just might get steam rolled - or you might get lucky and emerge unscathed. Those are not attractive odds - particularly since one or two successes can arm investors with false confidence when it may be just luck.
Putting a value on a stock need not require a high IQ or a math degree. However, it does require you to understand accounting principles and the ability to thoroughly read through the notes to a set of financial statements to gain a fuller financial snapshot. It requires you to use at least a basic valuation model which involves looking at least a couple of years into the company's future or being able to work with the information known today and calculating a value.
But it's fair to say that the market price may or may not be indicative of the actual value at a point in time. Also, the "true value" of a stock will not fluctuate nearly as much as its market price. It is this fluctuation above and below a stock's true value that will test the will and confidence of even the most experienced investors.
There are trends among individual investors that have been observed for some time. The most common ones are illustrated in the following sample comments I have heard people utter a number of times.
"That stock was $80 last year, now it's trading at $20 - so it's got to be cheap."
This is known as reference dependence, and it's the tendency to focus on some point of reference. But rather than focussing on where the stock was a year ago or the purchase price, the true reference point should be its assessed or calculated value. Only then can a decision be backed with confidence rather than volatile emotions.
"People aren't going to stop buying [pick necessity product of choice - i.e. food] so the company is not going anywhere."
This is perhaps the most common habit - i.e. confusing a good company with a good investment. Just because a company is good, it doesn't mean it's always a good investment. Not to mention that classifying a company as "good" or "strong" takes more than a superficial glance. Investors must be familiar with more than just a company's product or service. The history of management (and the impact and success of their decisions) in addition to corporate governance issues can provide real insight into a company's "goodness" and its sustainability thereof.
These behavioural tendencies result in many mistakes that ultimately cost investors money.
Okay, so you simply cannot resist the urge to try your hand at picking stocks. Then here are a couple of things to keep in mind.
Make sure you understand the business and the operating environment. That means having a strong grasp on what drives its revenues and expenses - both for the industry and the particular company. Running through what's called a SWOT analysis (Strengths, Weaknesses, Opportunities, Threats) will provide a basic framework that will force you to take a good look at the various aspects affecting a stock under consideration.
Don't buy a stock unless you have the ability and willingness to spend the time valuing the stock. Otherwise, you won't know when it's time to sell - an activity that most money managers tell me is the toughest part of the whole process to get consistently right.
I firmly believe that most individuals are best to stick to more boring investment activities - such as buying and holding a diversified portfolio of mutual funds, exchange traded funds, and bonds. While that doesn't offer the sizzle of playing the stock market, it has the substance upon which retirements plans may be built.
Dan Hallett, CFA, CFP is the President of Dan Hallett & Associates Inc. in Windsor Ontario. DH&A is registered as Investment Counsel in Ontario and provides independent investment research to financial advisors. He can be reached at firstname.lastname@example.org
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