Once you have chosen your investment strategy it is time to start learning how to build a stock portfolio. Your strategies should be inline with your overall investment strategy such as whether you are day trading and the level of risk you are looking for. Although we are sticking to stocks in this article, a lot of the principles can be applied to other assets as well.
There are thousands of different way’s to choose stocks and the chosen strategy can vary widely depending on the type of strategy you wish to employ and your objectives. Since there are so many we will look at some of the more popular strategies.
Note: For most investors choosing individual stocks is not always the wisest decision and should focus more on asset allocation and diversification. On a virtual trading site, however, we have the luxury of being able trade with large of sums of money and can make trades without worrying about the losses.
No matter what strategy you use, a stock screener is an absolute must to find what stocks you are looking for. With a screener you can easily select penny stocks, or ETF’s or find out which company has had a large increase in the few weeks.
Picking a portfolio of 100 stocks randomly has been proven, on average, to beat the market. So if you don’t know where to start, you can just pick random stocks and still hope to get a decent return.
A virtual exchange is a perfect location to practice high risk trading. To obtain a high risk portfolio, one would select penny stocks, triple leveraged ETF’s like oil 3X [htmwquote]UWTI[/htmwquote]. Penny stocks are generally just that, stocks that cost a few pennies. High risk may be scary but it also has the potential for huge rewards.
Buy What You Know
The best way to start of with picking stocks is to pick a stock of a company you already know about. If they have reached you as a customer, chances are they have done something right. If you see a company that not many know about that is becoming more and more popular with your friends you can get the stock before anyone even knows about it and hope to get huge returns. Another reason this works is because brand image is a very important and if you know the brand, then the company has already succeeded in something that has a lot of value.
Word of Mouth
On the other hand, one should generally not buy a company because a friend has recommended the stock because he made lots of money. In general, this strategy works very poorly since by the time you have bought you have already lost the potential for making money. This means the news you received from your friend that the company is a buy is usually quite old and stale. The other reasons is that even if you know someone who works in finance and is at the very forefront of news for a certain company, you still have to trust that he has given you a good buy.
This process involves researching a companies “Fundamentals” to try and ascertain what the value of the stock should be. Fundamentals include their earnings reports, forecasts, competitiveness in it’s industry and many more. Finance students will often learn about the fundamental analysis in university and is how most analysts come up with a stock rating. Essentially, if the stock’s value is under the current price, it would be a buy and if the stock’s value is below it would be a sell. If the value was roughly the same as the current price, it would be a neutral position (or hold) meaning you shouldn’t sell if you already have it but it is not a buy either. Analysts generally have one field of expertise in an industry they know more in, as the industry they are in is important.
One way to quickly look at stocks that could be worth purchasing is through P/E ratio or Price to Earnings. This gives an indication of how expensive a stock is with regards to it’s earning potential. A stock with a lower P/E ratio is generally more desirable than a stock with a high P/E ratio.
Using charts, patterns and a variety of other tools, technical traders try to predict what the market will do or determine the strength of a trend.
A very old adage in the stock market is that “The Trend is Your Friend”. When in a bull market buy you can buy the [htmwquote]SPY[/htmwquote] ETF to ride the trend until you hit a bear market and then short [htmwquote]SPY[/htmwquote] while in a bear market. Technical analysis can be useful here as well to get a better idea of whether the market is trending upwards or downwards.
Day traders typically use technical analysis to determine strength of a trend or predict a trend to make a profit over a few minutes to at most a day. In order to successfully day trade you will need to find stocks with higher volatility, have sufficient volume and have a low enough price to be able to invest larger quantities of money and thus be able to buy more shares.
A lot of investors like to have reliable companies with strong dividend history. By looking for high dividend yield’s and a good history of dividends, one can get a good reliable stock that will provide income every quarter or month.
“Too big to Fail” is the motto of this investment strategy. With this, someone would pick companies with very high market capitalization, that is to say, a very large company. This is essentially saying that the company has done well so far, why shouldn’t it in the future. These stocks tend to be “blue-chip” stocks as well.
This strategy essentially does the opposite of the market sentiment. When most people are buying, you are selling and when most are selling, you are buying.
One of the greatest investors of all time uses a variety of the strategies we’ve seen above but can be summed up pretty easily. Warren Buffet essentially buys great companies at a good price. Some of the ways he chooses an investment are as follows:
- Competitive Advantage – A company has to have a great competitive advantage over the competition. This could be anything from a patent to economies of scale.
- Brand – A good brand provides a huge competitive advantage, especially for simple every day things like ketchup and toothpaste.
- Reasonable Price – A great company isn’t a great company if it is very expensive right now. Warren buffet has said that what a company costs is the price, but what you get is the value.
- Proven – A company has to have a long and stable track record of earnings before he will invest in them.
Warren Buffet’s approach is therefore close to someone using fundamental analysis but throwing out anything that isn’t a good company with a great brand.