This is the last article in our guide to understanding stocks. In this article, we show you what it takes to invest in stocks for the long term. If you’d like to read the last article, which described why stocks move the way they do, click here.

Introduction

Buying stocks for the long-term isn’t easy.  In fact, most professionals, academics, and really anyone that knows about investing would probably tell you to buy a basket of mutual funds instead.  It’s easier, more diversified, and considered to be safer.  That, combined with the fact that there are literally thousands of highly paid professionals whose whole reason for being is to research and invest in stocks, means that you’ll be fighting uphill the whole way.  In fact, there’s a whole branch of finance taught in most schools whose sole purpose is to prove that you cannot consistently outperform the market as a stock-picker.

But with all that said, you may still want to learn about how to research and analyze individual stocks.  After all, you may be just as good as all those guys working on Wall Street, and if you’re dedicated, don’t get greedy, and follow some simple rules, you can definitely achieve lasting success.

No single article can turn you into an expert stock investor, but in this article we’ll try to hit some of the most important points, hoping you will continue your research and, eventually, start generating some steady returns.

Diversification

The most important concept in investing is risk management.  Before we even bring up any ideas on analysis or research, there’s one thing you need to always remember, and that is to diversify.  There are few things worse than having one bad pick wipe out half your portfolio, and believe us, that one bad pick will definitely be there.

Diversification is your friend.  It exists to help you, to save you money, to reduce your risk.  Use it.  Don’t put all your retirement money in the stock market, and with the money that you do put in the market, spread it out over multiple stocks in multiple sectors.  Never place a large fraction of your portfolio in a single stock.  We’d consider 5% the maximum amount that you should put in any one position.

Diversification is extremely important, and it will usually help with preventing large losses.  But there are a few “gotchas” that you need to watch out for.  First, it is possible to over-diversify (the reasoning behind this is technical and gets too far into financial theory, but suffice it to say, you can have too much of a good thing).  If you take on too many positions, you may be putting a pretty big dragnet on any high flying stocks that you’ve chosen.  Finding the right amount of diversification for your portfolio is a fine art, and you’ll need to consistently monitor your positions to find the right level.

Also, keep in mind that owning multiple stocks doesn’t necessarily mean you’re properly diversified.  The main thing to keep in mind when you diversify is that you want to eliminate stock-specific, or industry-specific risk.  That means that buying Ford to diversify away from Toyota is generally not a good idea.

Know the company (fundamental analysis)

Research the business

When you buy (or short) a stock into your portfolio, you’re inherently taking on the same risks and rewards that the underlying business has.  That means that you better know your companies extremely well.  The most diligent investors on Wall St. literally spend thousands of hours researching potential buys and sells before adding them into their own portfolios, and, for the most part, you can get the same information that they can.

Sure, sometimes they have quick access to CEOs and managers in the company, but the foundation of their research starts with information that you can get just as easily as they can.  One of the best places to learn about a company is the investor relations page of its website.  On that page, you should have access to details about company management, financials, and links to mandatory reports and filings that all publicly traded companies have to make.

The most important of these reports is called the 10-K, which provides more details than you’d ever want about a company.  It will tell you everything from what that company does, to what its sales and profit margins are, to the terms of its leases on its most important real estate.  Company management has to sign off on its accuracy, and oftentimes, the CEO and CFO provide key comments and notes that are incredibly useful for investors.

In addition to reading the 10-K, you can listen in on analyst and management conference calls during earnings season, set up news alerts on the company, and even visit some of its stores to see how sales are doing (when possible).

You can also research what management is doing with their own shares in the company.  Are they buying?  Are they selling?  How much?  Why?  Sometimes the way that company management acts can be an indication of what they expect for the company’s future (just be careful about putting too much emphasis on this, as managers aren’t allowed to trade on any information that hasn’t been made public).

Your goal in all of this research should be to gain as much insight on the company as you can.  Get as much information as you can, and then make an assessment on how you think it will do in the future.

Evaluate performance

After you’ve done your investigative work, your next step should be to assess how the company has been doing in the recent past.  Take a look at its balance sheet and income statements for the past year and compare it to the past five years.  Has its debt gone up?  Have profit margins dropped?  Have they been gaining or losing cash?  Taking a look at the cold, hard numbers is sometimes the best way to determine where a company is going.

Some of the data you should look at include:

• Debt-to-equity ratios (many times, when debt starts to grow, you want to be cautious)
• The current and quick ratios (does the company have enough cash to pay off its immediate debts)
• Profit margins, return on equity, and return on invested capital for the past 5 years (an upward trend is always good)
• Growth in sales and profits over the past five years (have they been selling more while keeping their costs down)

The list above is just a starting point.  There are a large number of different ratios, fractions, and numbers that you can examine, but in the end, your goal is to find out one thing: how’s business?

Know the stock (technical analysis)

After you’ve determined if the stock you’re looking at has a good underlying business or not, you need to figure out if the stock itself is a good buy (or short).  It’s entirely possible to have a good business that’s not a good stock.  The first thing you may want to do is value the business and determine if the stock’s current price is overvalued or undervalued.  You can either use a method of discounted cash flow valuation, or the P/E ratio, or preferably, both.

By first finding the true value of the company’s stock, and then looking at the P/E, you can find out if the market is overvaluing or undervaluing the stock both in terms of absolute dollar amounts, and with respect to how it has done so in the past.  If a stock’s current P/E ratio is low compared to its historic average, it could mean that the stock is a good buy (however, it could also mean that the underlying business is in trouble, this is where your fundamental analysis can help you make a judgment).

In addition to valuing the stock, you should also take a look at the company’s earnings per share, or EPS.  If this number is high compared to historical values and the company’s competitors in the same industry, it may mean that the company is doing well compared to its share price.

Some investors also like to look at chart patterns to determine whether it’s a good time to buy or sell the stock.  Though we wouldn’t suggest trading stocks based on patterns alone, you could use chart analysis to time when you plan to get into, or out of, a new position.  Some patterns like moving average crossovers and MACD crosses may help you get a better price on your trades.

When it comes down to it, you should always keep in mind the fundamental saying: “buy low and sell high.”  It’s your job to determine what “high” and “low” mean for any given stock, but as long as you follow this rule, act greedy when others are fearful and fearful when others are greedy, you’ll make a hefty profit.

Dividends

Dividends are some of the most important things when it comes to buying stocks.  A dividend is a payment from the company to you to provide you with a share of the company’s profits.  Believe it or not, most of the value in owning stocks comes from dividends, not price appreciation.  Owning stocks that pay dividends is extremely important.  In fact, many investors only own dividend-paying stocks.  You may want to consider doing the same.

Dealing with losses

Inevitably, no matter how much research and analysis you do, you’ll run into a stock that will go against you.  It’s important to have a plan in place for when this happens.  You have a few different options.  You could always use options to limit your losses while holding onto your underlying stock.  You can learn more about this possibility in other articles on this site.

You can also choose to do what’s called “dollar cost averaging,” in which you invest a small and steady amount continuously, buying more shares when prices are cheap, and less shares when prices are high.  Though dollar cost averaging can potentially lower your cost basis, it’s not without its disadvantages.  The last thing you want to do is catch a falling knife and invest more money when your pick is going against you.  That’s why we recommend the use of stop losses.

Stop losses automatically get you out of your position after you’ve lost a certain, pre-set limit.  It’s only natural for us to fall in love with the stocks we buy, and when they start going against us, our natural intuition is to hold on to them, hoping they’ll rebound.  By always using stop losses, you take emotion out of the picture, and you implement a systematic way to always limit your losses.

The most important thing with dealing with losses is to actually have a plan in place before they occur.  If you wait to figure out how to deal with your losses until they actually happen, chances are you won’t do what’s best for your portfolio.

Shorting

Shorting a stock involves borrowing that stock from your broker and selling it on the market in hopes that the price will drop, allowing you to buy it back at a cheaper price and pocketing the difference.  Shorting definitely has its merits, but shorting an underperforming company is significantly different from buying a strong, solid company.  It also comes with several drawbacks, including the possibility of having to pay any dividends that have been issued while you’ve been short, having to buyback the stock immediately if the lender of the stock wants it back, dealing with possible bans on shorting (as was the case with financial stocks during the financial crisis), and maintaining proper hedges and controls on your short position, particularly in light of your entire portfolio.

Point being, unless you really know what you’re doing, try to avoid shorting stocks.

Final tips

When you find a stock that you’d like to buy or short, you may want to think about scaling into and out of positions.  Consider buying (or shorting) only a small portion of it to start with, and slowly buying more if the position goes in your favor.  By avoiding investing all of your money at once, you set yourself up to avoid large losses.

Before you invest your first dollar, it’s important for you to commit yourself to being disciplined, developing a plan for finding new stocks, limiting your losses, and avoid getting emotional.  You’ll undoubtedly experience highs and lows when investing, and as long as you don’t let them control your judgment, you can make consistent profits over the long run.

That wraps up our guide to stocks.  Hopefully you feel a bit more comfortable with stocks, the stock market, and investing in general.  At this point, you should keep reading and doing more research to understand if investing in individual stocks is the right process for you.  If not, there are always mutual funds and options, which you can learn about from other articles on this site.

Good luck!