Beginner's Guide to Investing in Stocks

By David Sterman
October 15, 2010

Trading can mean a lot of different things. Some traders buy and sell every day. Some only trade a few times a year. Computerized high-frequency trading desks at big banks and hedge funds trade every nanosecond.

If you're a beginner who's a little intimidated but still wants to get in the game, it's tough to figure out where to start. And if you're an experienced trader that thinks it may be time to get back to the basics, it's nice to take a refresher course on time-tested wealth-building concepts. That's why I thought it would be a good idea to put my 11 best pieces of advice down on paper.

There's certainly no shortage of investing ideas out there. Watch CNBC for an hour and you'll be bombarded with at least a dozen. The financial media makes sure that you have plenty of stock candidates, and it's their job to make every investment idea look as compelling as possible. But if you bought every "great" stock you came across, trading commissions would soon eat up your portfolio and you'd find yourself in the poor house.

So it's your job to pick the best ideas, and then execute trades in the most cost-effective manner. And because none of us have an unlimited set of funds with which to invest, it’s also your job to know when to exit an investment.

This list can serve as a blueprint of how to make sure you are making the right moves to build your wealth. Internalize the list -- most of the other traders out there already have. It's the good traders, not the uninformed suckers they buy from and sell to, that you want to emulate.

Dave's Rules #1-3

1. Come up with a game plan.
What are you looking for in an investment? A stable dividend-paying blue chip may offer more in income (great for an income investor) than it does in a rising stock price (bad for a growth investor). Maybe you have the stomach for stocks that have potential to rise sharply, but that could go to zero if the idea doesn't pan out. Are you happy to stay stateside, or would you prefer some exposure to another part of the world?

You should probably have at least some exposure to all these types of investments, but establishing a game plan upfront is vital. The road map you create should stand the test of time, so really spend some time on it and be honest with yourself about your risk tolerance, your financial needs and your long-term goals.

After you create your plan, don't put it in the filing cabinet never to be seen again. As you trade, ask yourself if your portfolio still has the mix of investments you initially targeted.

2. Set aside time for research.


In any given month, I look at 20 to 30 different stocks, hoping to find a handful that strike the right balance between risk and reward. You may not have the time or inclination to look at that many companies, but if you want to trade, you need to set aside some time every week to look at stock ideas. If you don't enjoy researching stocks, then you are better off investing in a mutual fund

Even if you do enjoy the research, you'll need to find ways to keep the process fun. I like to plug numbers into spreadsheets to compare companies. That's my idea of "fun." You may prefer to do research by reading the daily paper and staying abreast of international events. Others like to go to shopping malls to see which retailer's new line of clothes is generating the most buzz. Peter Lynch famously discovered Hanes stock because his wife loved their L'Eggs brand pantyhose. Inspiration can come from anywhere.

Remember that when you first discover a new stock idea, whether on a news program or during your designated research time, there's a good chance you're only hearing the positives. One of the easiest ways to get a ton of information in a short amount of time is to go back and listen to the recording of the company's last conference call. Conference calls run through all the topics important to investors -- good and bad. Plus, you can piggyback on the specialized knowledge of Wall Street analysts who take part in the Q&A session at the end of each call. They are paid to wade through the minutia of financial statements and ask management about any red flags. You can glean a lot of (free) information from their conversations.

Ideally, find the time to listen to several conference calls in chronological order to get a sense of whether management is meeting targets they've established, or simply coming up with excuses for why results are below expectations. And never give management the benefit of the doubt.

3. See how your picks compare to their peers.
Once you've selected the stocks that are most appealing, check out how they stack up against their peers. The best stocks often have the highest sales growth, the most robust gross margins, the highest returns on equity (ROE) and the cleanest balance sheets. There is rarely a reason to own the second-best or the third-best company in an industry, unless its stock price is far cheaper than the industry leaders. Leaders, as measured by these financial yardsticks, typically generate the highest investment returns year-after-year.

While you've got your calculator out, take some time to compare the performance of the company year-over-year, using these same metrics. Look at the last three or five years -- unless the economy has been in a funk, financial metrics should be improving year-over-year. If annual results are all over the map, then this is a business that is unlikely to ever be highly-valued by investors.

Dave's Rules #4-6

4. Check for five red-flags.
I have five no-no's that automatically disqualify a company that's made my short list: 1) an increase in debt coming due in the near-term (classified as "the short-term portion of long-term debt" on the balance sheet); 2) inventories rising faster than sales; 3) a change in the chief financial officer (CFO) without a good explanation; 4) a history of negative free cash flow; and 5) heavy insider selling.

5. Know where you are in the economic cycle.
Certain sectors fall in and out of favor depending on where we are the economic cycle, and investors can take advantage of this phenomenon by practicing "sector rotation."

As an economy slows down, investors turn defensive and retreat into consumer staple stocks like Procter & Gamble (NYSE: PG) and Coca-Cola (NYSE: KO). These companies generally don't see much damage from a slowing economy and are seen as safe harbors in the proverbial storm. Once an economy looks like it has hit bottom and may start to turn around, investors tend to go small, buying shares of small caps and other speculative plays that have been sold down to very low levels. 

Once economic data points start to look better and investors are convinced the cycle has truly turned, they rotate into housing and auto stocks. (Housing stocks have yet to find any affection in this market, though they have tended to flourish at this stage in past economic cycles.) Later on, investors move into "late cycle" plays like Caterpillar (NYSE: CAT) and U.S. Steel (NYSE: X), as these companies really get going when the economy is humming.

Knowing the natural rhythms of the market can help whittle down the companies you should be looking for at any point in time. Learn more by checking out our educational piece, Sector Rotation: Find the Best Stocks to Buy Now.

6. Determine the right allocation percentages.
Assuming all your research checks out, you need to figure out how much of any particular stock you should buy. As a general rule of thumb, the less risky a stock, the higher the percentage of your portfolio it should ultimately be. But risk is relative. Some investors only invest in small-cap stocks, which are considered to be riskier than blue chips. By that logic, the most stable small-cap in your portfolio should be the biggest holding.

Portfolio managers suggest that you can get all the diversification you need with just 10 stocks. If you currently own 30 stocks, and each comprises 3% of your portfolio, you should consider selling the stocks that you don't know much about and re-investing those proceeds back into the top 10 stocks that you know best. As a general rule of thumb, no single stock should make up more than 15% to 20% of your portfolio.

Dave's Rules #7-9

7. Be patient.
This is the hardest part of investing. Many investors jump into a stock before they know much about it, a mistake almost every time. And because many investment professionals disparage keeping cash on hand because "it's not doing anything for you," traders often forget that even when you're feeling very bullish, you should always keep some powder dry.

Experienced investors will tell you of the sheer frustration that comes with waiting and waiting on a great investment idea, only to have no money to buy when the opportunity appears. Sometimes great companies get sharply penalized for messing up a quarter -- this can be a great time to pounce. By keeping a little "rainy day" cash on hand, you can make sure you don't miss out on a great company trading at a fire-sale price!

(Even more important than retaining cash is the need to be debt-free. You probably shouldn't be buying any stocks if you are carrying high-interest debt, as you'll need to overcome those interest rates in the form of higher investment returns just to get ahead. And that's no mean feat.)

8. Know whether to use a limit or market order
If you want to buy 1,000 shares of IBM (NYSE: IBM), you don't need to worry about whether you'll move the stock price (you won't), so you can usually get away with using a market order.

But smaller stocks can be tricky.  A similar order for a micro-cap stock could push the price higher as shares are found to complete your order. You may only be able to fill 100 shares at the quoted price. The next 900 shares may be filled at ever-rising prices. (And the converse is true for sell orders). If you place a big order, you may find that shares were bought at prices 3% to 5% higher than you expected.

And that eats right into the profits you hoped to make. That's why it's best to place a limit order with your broker, specifying the maximum price that you are willing to pay.  And be sure to specify whether that order needs to be filled today, or if you're willing to be patient. If that's the case, "good-til-cancel" is your best bet.

It may take the broker several days to fill the entire order, but at least you'll be protected from getting a bad price. Alternatively, you can wait for the day when the stock you're watching is seeing a lot of trading volume. The higher the volume, the tighter the spread between the bid and ask price, and the more likely it is that the order will get filled at the price you want.

9. Stay on top of things.
Once you're in a stock, you need to spend as much time researching that stock as you spend researching any new ideas. Avoiding losses on any stock you already own is just as important as making money on a future stock.

As a first step, read all the news affecting a stock in the last 60 days on a website like Yahoo! Finance. Other websites, like StreetAuthority.com, have a handy search engine where you can find all that has been written about a company recently.

Even as you read as much as you can about your stock, remember to trust your gut. You may come across information that appears bad, yet the stock doesn't fall as expected.  That's because investors are often slow to react to minor bad news and only dump a stock upon hearing really bad news. In many cases, the minor negative news you just came across is a harbinger of much worse news to come.

It's so important to know that Wall Street analysts can be very slow to react to news and can't be counted on to give a timely heads-up that something has changed. For example, you may read that a rival just lured a key customer away from a company whose stock you own, increasing the odds they will see downward earnings revisions down the road. The analyst following your company may not revise his estimates until the company actually reports a decline in earnings. I use Wall Street research to help me better understand the background of a company, but prefer to draw my own conclusions as to whether a stock is a buy (or sell).

Dave's Rules #10 and #11

10. Check and re-check your reasons for owning a stock.
Investors typically have clear reasons for owning a stock. Perhaps its gross margins are rising. Or the company's new line of products is expected to see strong demand this year. That investment thesis is why you bought the stock, and is the only reason to own it.

Yet many investors delude themselves into believing there are additional reasons to own the stock if the initial investment thesis peters out.  If the company you bought for its rising gross margins now says it's focused on growing market share instead, that's a reason to sell. If a company's promising new product is being abandoned and management decides to grow through acquisitions, that's a reason to sell. Be ruthless.

As pointed out in the cleverly titled Breaking Up With a Bad Investment, John Persinos points out the following rule of thumb: Any equity you now hold but no longer consider to be a "buy" candidate should be a strong contender for sale.

11. Know when to get out.
As noted, there are two reasons to sell a stock. Either it has appreciated to the level you wanted, or your original reasons for owning it are no longer in place. Take the emotion out of trading by sticking to your guns and selling. That's why you have a plan in place. If you can't sell, chances are you're emotionally attached.

 

[Click here to see the 5 Signs Your Emotions Are Taking Control of Your Investing.]

Once you sell, don't give up on all that valuable information you accumulated while you owned the stock. Capitalize on all that knowledge you built up analyzing the company. I have owned several stocks multiple times over the last 15 years and I know it pays to create a watch list of stocks you've owned in the past. Take a look at the latest news and stock price movements for each stock once a month to see if business is improving or if the share price has become more attractive.  Always be ready to rekindle that old spark.