This is a great question that is asked, at one point or the other, by just about every investor and would-be investor in the game.
After all, no one wants to lose money in the market (even though everyone will lose money at some point in their careers if they trade long enough). We all want to win – so we all look for the best system.
The truth is, there is no “best system” for trading the stock market. Different strategies have worked for different people, and ultimately the way you invest depends on your personality, your finances, your risk profile, and your goals.
With that being said, there are sound principles you should follow when it comes to investing in stocks to increase your chances of coming out a winner.
Diversify, Diversify, Diversify
Out of all the stock investment tips I can give you, this is perhaps the most important. Diversification – or, spreading out your stock purchases among several different sectors and industries – can spread out your risk by limiting your losses if one or two stocks go south. It’s the equivalent of not putting all your eggs in one basket; if you trip and fall, your eggs are going with you.
If you diversify, though, there’s a good chance that your winning stocks will balance out and even overcome your losing ones (except for when the entire market takes a nose-dive, but that is not as common as you think).
This means buying in several sectors and industries, like buying energy stocks, retail stocks, manufacturing stocks, and tech stocks. This can also mean going a step further and diversifying by market capitalization (defined as the number of outstanding shares multiplied by the stock price). It’s a good idea to have some large-cap stocks (over $10 billion), mid-cap stocks ($2 billion to $10 billion), and small-cap stocks ($250 million-$2 billion) to insulate against losses.
Of course, diversifying too much can limit your returns, so find that balance.
Learn Key Financial Indicators
Another essential part to investing in stocks is to learn how to use key financial indicators that reveal signs of the company’s financial strength. Buying on trends and trying to time the market is great when it works, but at the end of the day, you’ll consistently achieve results if you incorporate a heavy dose of value-based investing into your strategy.
There are two metrics that you can use to gauge whether a stock is a value buy. The first is to look at the well-known price-to-earnings (P/E) ratio, or the stock price divided by the company’s earnings per share (EPS).
This is also known as the “earnings multiple”. The P/E ratio can tell you how expensive the stock is compared to how much the company is earning. Between two companies in the same industry, a higher P/E means that stock is more “expensive” – but that the market expects that company to generate higher earnings.
An excessive P/E ratio can be a warning signal that a stock is overvalued. A low P/E ratio for a company, when compared to its industry and peers, could suggest that the company is undervalued if all other financial data indicate that the company is on solid ground.
Another indicator that goes further than the P/E ratio is the enterprise value of the company. This is calculated by taking the market capitalization of the company, adding its total liabilities, and subtracting how much cash it has.
EV basically tells you how much a company is worth. By itself, it can be useful, but it’s even more useful when you use it to with the company’s cash flow. This is called the EV/EBITDA multiple (or enterprise value/earnings before interest, taxes, depreciation, and amortization).
In general, a low EV/EBITDA multiple could suggest that a company is undervalued. Industries that experience high rates of growth, like the biotech industry, tend to have higher EV/EBITDA multiples.
This metric is useful when you compare stocks within the same industry and can help you find undervalued stocks.
Sell Losing Stocks, Ride Out Winners
When you actually choose a stock to invest, you need to be disciplined about how you react to the market and the stock’s performance.
If your stock goes south, and it doesn’t show any signs of rebounding or of higher earning potential in the future, you need to cut your losses. One of the biggest reasons why investors fail is because they hold onto stocks that continue to lose money day after day. You will lose on some trades; the secret to long-term success is to minimize your losses as much as possible.
If a company is on sound ground (because you did your research), you may not want to sell – especially if you’re in for the long run.
If you have a stock that is gaining, why not keep it a bit longer than you normally would to see if it will continue to gain? After all, the worst that can happen is that the stock backslides a bit.
If you sell at that point, you’d still keep your profits. And, if you hang onto the stock long enough, you could see it go even further. Every successful trader needs to come across a few of these kinds of stocks every now and then.
Always Find Value
Lastly, to go along with using the metrics described previously, try to find underlying value in every stock you purchase. Paying less for a solid company than it is really worth because the market price just happens to be low is definitely better than paying more for a solid company that is on a hot streak.
There’s a lot more upside potential to the first company, and you are spending less to get that advantage. While you want a mixture of growth stocks – stocks with high cash flows and growth rates compared to their peers – and value stocks, having value form the basis and foundation for your strategy is a wise idea.