How to start investing profitably in individual stocks

So even after reading my warning, and despite all the ease, simplicity, lower risks and excellent returns of target date index funds, you still want to pick your own stocks, huh? Ok, keep reading, but don’t say I didn’t warn you!

Stock-picking Acid Test: do you have at least $100,000 in stock index funds? Have you paid off all high interest debt like credit cards? Are you on track to retire by at least 60-65? If not, go back to the basics first before you consider buying individual stocks!

I recommend keeping at least 75-90% of your portfolio in index funds such as a Vanguard Target retirement fund, and only allowing yourself to pick stocks for the other 10-25%.  That way, if you lose your shirt, you’ll still have plenty of assets to fall back on.  Alternatively, you could designate your retirement funds as index-only, and stick to taxable accounts for any stock picks.  I do this, since I don’t want to screw up my age 60 retirement accounts (401k & IRAs), but am willing to take a little more risk on my ‘early retirement’ accounts.

Also, diversification– owning several different stocks of different sizes in different industries– helps you lower your portfolio’s risk.  The right index funds give you that diversification so that you don’t have to worry about it as much when you’re picking individual stocks.

Quick start guide to picking your first stock

  • Start small (cap.) small investors have better chances beating the market than large investors when it comes to the sizes of companies they can profit from. Choosing a small cap company with a market cap between $500 million to $2 billion means you’re competing with far fewer institutional investors.
  • Learn how to read financial statements. Get your company’s latest 10-Q (quarterly report) and 10-K (annual report) and read it from cover to cover, skimming as needed.
  • Have the right attitude about valuations. The market’s prices are there to serve you, not to inform you. Every single company, which is what a stock represents, is undervalued at one price, appropriately valued at another price, and overvalued at yet another price. You’re investing in a partial ownership of a business enterprise; you’re not playing a casino game. As Ben Graham famously said, “in the short run, the market is a voting machine but in the long run, it is a weighing machine.”
  • Understand how you can be fooled by randomness, and understand why ‘value investing‘ (<– famous Buffett essay)– broadly interpreted as trying to get more business value than the cash you give up in buying a stock– is the ONLY way to invest with a hope of beating the market.

Educate yourself

Peruse investing education websites like the Motley Fool (which unfortunately has a lot of link-baity junk too; but you can still find some good stuff on investing like this, or this.)  MoneyChimp is a great site too, with many investing (and general personal finance) calculators available.

Read superinvestor Warren Buffett’s ‘Letters to Berkshire Hathaway shareholders’ for free online (or consolidated in a much easier format in this book.)  The best book I’ve read to get a feel for the correct general investing philosophy is Roger Lowenstein’s Buffett biography.  I recommend this as a must-read for any would-be investor to learn the correct investing temperament, which is even more important than  learning how to value stocks.

Read Benjamin Graham’s classic ‘The Intelligent Investor’, or at least the chapters on ‘Mr. Market’ and the Margin of Safety concept (Chapters 8 and 20.)  Graham was Buffett’s teacher and, together with David Dodd, pioneered value investing with ‘Security Analysis’.

Peter Lynch’s One up on Wall Street and Beating the Street are also good. Philip Fisher’s Common Stocks and Uncommon Profits is excellent too, especially for the notion of ‘scuttlebut’; picking up (legal) insider tips on your own.

A less dense and very useful ‘just get started investing’ primer is the Motley Fool’s Million Dollar Portfolio book.

One word of caution: if you ever come across ‘technical analysis’, otherwise known as ‘charting’, run the other way as fast as you can!  Technical Analysis is a stock picking method akin to voodoo (and just as scientific.)  It involves looking at the past patterns in past price data (random movements in the market) for a given stock.  Supposedly, patterns like ‘head and shoulders‘ (I’m not making this up) are ‘buy’ indicators, whereas the ‘rounding top‘ pattern is something to fear.  If you think trying to divine future stock movements from random patterns in past price data sounds crazy, you’re right; don’t give this garbage any space in your brain.

Do your homework

Once you find a company you’re interested in, start looking at their financial data and business model. I use Yahoo! Finance for a quick look at financials and to track companies I’ve already bought or am considering buying in the future. Download annual reports (10-K’s) and quarterly reports (10-Q’s) from the Investor Relations section of a company’s website. Do whatever valuation techniques you like, but at a minimum compute some ratios (PE, PEG, Current, Quick, etc) and do a Discounted Cash Flow (DCF) analysis on a company’s Free Cash Flow (FCF.)  Valuation matters!

Plan to buy and hold a company… forever!

Warren Buffett is often quoted as saying his favorite holding period is forever.  What he means is that if you do a thorough job in steps 1 and 2 above, you should have found a company worth holding for a very long time.  Ideally, that great business would continue to be a profitable investment for years to come, so why wouldn’t you keep the stock?  There are some legitimate reasons to sell, maybe the business has changed, or maybe you overlooked some glaring issue at the time you purchased.  Maybe the all-star CEO has left and you’re not comfortable with her replacement.  Or, maybe you finally need the money.

Other than these reasons, plan on holding for a very long time.  Buy and hold investing forces you to do your research up front.  It also keeps you from trading too much, which incurs large costs and lowers returns dramatically.  Not only that, but the IRS tax code favors investors who hold their investment gains as long as possible (this last consideration doesn’t matter for retirement accounts that are tax-advantaged, like 401ks or IRAs.)

Track your portfolio’s performance against an appropriate benchmark index

Here’s the easiest way to do this, which is what I do to track my performance casually and easily.

Knowing your performance against a relevant benchmark. If you can’t beat the market benchmark, picking stocks is detrimental to your wealth AND a waste of your time. I recommend keeping your brokerage account that you use for individual stocks separate from the rest of your investments (i.e.: your index funds, bonds, and cash reserves.)

After you calculate your total return, calculate what your total return would’ve been if you’d made the same investments (amount and date of investment) in an index fund like the Vanguard Total Stock Market index fund (ETF ticker: VTI.)  Ideally you would like as long a time period as possible, as random fluctuations in your portfolio can make you lucky (or unlucky) in the short term.  Check your portfolio’s return against a benchmark at least every 6 months to a year.

If you can outperform the market for 3 years or more by a 1-2% each year, you’re doing very well. If you’re doing better than that, you’re crushing it compared to most investors. That might not sound like much, but it is when you can keep up that performance year over year. You might also compare the dollar gain vs the time you’re spending on it.

Conclusion

It’s very difficult to gain the knowledge, emotional attitude and discipline to be a successful stock picker. By using the resources about you’ll have a better chance than most, which still may not be enough. Stock picking can be fun, but make sure you’re giving yourself constant reality checks by measuring your entire portfolio’s performance against a major stock market index fund like the S&P 500. Use a buy and hold strategy with a long-term (5+ years) holding period. Thoroughly investigate the pros and cons of every investment before you buy. Good luck!

Final word of caution and advice

Be brutally honest with yourself: if this all sounds like too much work, or if you know that your initial excitement to do the work will lose steam in a few months, just buy broad low-fee index funds. Just ‘buying the market’ will result in huge compound returns over time, and beats the vast majority of professional money managers (because of their fees + taxes they generate from more frequent trading), not to mention all your friends.  Not only that, but target date index funds require practically ZERO work and maintenance, allowing you to ‘set it and forget it’ and get on with the rest of your life.

Author: Ward Williams

Personal finance blogger with an interest in saving, investing, and learning new skills and doing things for myself & others!