So You Want To Pick Stocks? Know This First
The one question I dread from friends and family the most is “what do you think of this stock?” Not because I don’t want to help (I do!), but rather because a profitable stock picking strategy requires a process that focuses on probabilities of success across many different stocks instead of just one. As I mentioned in a previous blog, the first answer to this question is “it depends.” How long is the planned holding period? Do you have an exit plan if the market doesn’t agree with your assessment? Picking stocks instead of using ETFs or mutual funds carries a certain appeal as it taps into our inner competitor. It is also one of the hardest games to play since the competition resembles something like the Monstars from Space Jam. To be profitable, there needs to be a well-defined system in place and even that isn’t a guarantee of success.
For starters, there are two main ways to analyze a potential investment: fundamental analysis and technical analysis. Fundamental analysis consists of analyzing a company’s business prospects. After all, holding a share of stock is owning the rights to a small piece of that company’s profits. There are many ways to attack this, but good fundamental analysis typically involves pouring over a lot of data in quarterly and annual statements, learning about the industry and competition, and modeling out potential outcomes for the company given certain assumptions. It is a lot of legwork! This is compounded by the fact that your competition in this endeavor is billion-dollar institutions with an army of analysts who can churn out a complex Excel model over lunch. Another challenge with this method is you could be 100% correct on your analysis, but the industry in which your target company resides is out of favor for a long period of time. You could have to wait years for your thesis to play out. Most people sidestep this challenge by owning a lot of different stocks via an index or a diversified portfolio so that they don’t have to outsmart the other players.
Technical analysis refers to the analysis of price itself by using charts as a visual aid. They say a picture is worth a thousand words and a chart helps to visualize where price has been. In fact, the first thing I do when somebody asks what I think of a stock is pull up a chart. Is it trending in the right direction? Is it running into potential resistance from people looking to sell? Is it overextended from an ideal buy point? There are many different flavors of indicators and chart analysis techniques one can use, but it is my preference to keep it relatively simple: identify trends and look for profitable entry points. All the caveats from fundamental analysis apply here as well – you aren’t the only one looking at these charts.
The “final boss” in this challenge is one that resides between your ears. Investing decisions can wreak havoc on emotions and rationality. It’s why there is an entire swath of the book industry dedicated to investor psychology. Irrespective of which method you choose, it would be foolish to think that any analysis or chart would give perfect prescience into where a certain stock is headed. The goal is not to bat a thousand on one investment, but rather to keep a profitable batting average across an entire portfolio. Warren Buffett has a spin on the adage that warns against putting all your eggs in one basket. He said, “Keep all your eggs in one basket, but watch that basket closely.” If you are going this route, you need to think like a gardener: weed out what isn’t working to help your flowers grow. If you would rather outsource this landscaping, send me a note.
Author: David Rath, CFA
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