.Question #5: How do I know which stocks to buy?
Answer: Entire books have been written on this topic, but most stock
analysis boils down to a few key themes:
Value. Even the fastest-growing stock isn’t worth buying if you must
overpay. Beginners in particular shouldn’t mess around with pricey
hypergrowth stocks. Before you buy, consider the stock’s key valuation
ratios (price/earnings, price/sales, price/book, and price/operating
cash flow).
Growth. Even the cheapest stock isn’t worth buying if the company
can’t increase its profits. Rising sales, profits, and cash flow suggest the
company’s products sell well enough to increase its penetration of the
market.
Profitability. Any company can grow if it spends enough money. Wellrun companies can maintain their profit margins while still growing.
Investors should target stocks with stable or rising profitability.
News. What kind of headlines does the stock generate? Both good news
and bad news can affect a stock’s price before any changes trickle down
to the income statement or balance sheet.
Comfort level. If a stock will keep you up at night for any reason, don’t
buy it. This rule applies even if the stock skyrockets or if all of your
friends load up on the hot name. No investment, even a profitable one,
makes sense for an investor who can’t buy into the idea as well as the
stock.
Question #6: How do I know when to sell a stock?
Answer: Entire books have also been written on this topic. Most
investors find the sell decision tougher than the buy decision because they
only buy stocks they like. Once you purchase a stock you enjoy owning, you
may find it difficult to part with the investment.
That said, there is no such thing as a permanent buy. Eventually, every
stock outlives its utility in your portfolio. All stocks move up and down over
time, but the ugly plunge of bank stocks in late 2008 and 2009—far worse
than the decline in the broad market—illustrates the dangers of sticking
with stocks when their environment changes substantially (see Figure 2.1).
Fundamentals of the Stock Market
Figure 2.1 – Don’t Bank on It
1) The reason you bought the stock no longer applies. In other words, if you
purchased the stock because of its valuation, does the valuation still look
attractive? If growth drew you in, has that growth continued? If the
answer is no, consider selling.
2) The company has fundamentally changed. Sometimes that drug company
you purchased because of its pipeline of asthma drugs changes its
direction and starts to focus on mental-health treatments. If you like the
first approach but not the second, don’t be afraid to sell.
3) The business has fundamentally changed. Bank stocks illustrate this
concept well. Back in late 2007 and early 2008, when a few critics began
grousing about banks overextending themselves, many investors bailed
out on their stocks. Before that, the rise of the Internet presaged the
decline of newspapers. Investors who heard the train coming and sold
their newspaper stocks in 2004 and their bank stocks in 2007 profited
from their ability to see and from their willingness to accept the new
reality.
4) You need the money. This one may sound silly or obvious. But didn’t you
start investing to build wealth to cover expenses, either now or in the
future? If you bought stocks to cope with your daughter’s college costs,
sell some of them when the first tuition bill comes due, even if you still
think all of your stocks make good investments. This does not mean you
should sell a few shares just because the car needs new tires. You should
have an emergency fund to cover that kind of expense. Even if you
purchase stocks with the intention of selling them fairly soon, your stock
portfolio as a whole serves a purpose with a longer time horizon.
Basic Questions About Investment.
