Where To Invest As A Beginner
So, you read my first article in this series and decided it is time to put your money to work in the stock market. While I could give a rote list of stocks to buy and leave it at that, it is far more useful to provide you with the knowledge to differentiate for yourself a solid investment from a poor one. We can easily fall into the trap of believing that everybody else is more financially savvy than we are, especially since most people do not broadcast their lowlights. However, I can admit as a trader that I’ve made many mistakes as it relates to personal investing. I will describe some of the misconceptions I previously held and what time and failure have taught me about them. Hopefully you can learn from these mistakes and develop confidence in your own ability to be choose stock.
Misconception #1: I must be an expert stock picker, always correctly choosing the next hot stock that blows up and makes the front page of the Wall Street Journal.
The reality is that even the “expert” stock pickers are only right about half of the time. They are able to still come out on top overall due to the proven strategy of diversification.
If you’ve ever heard the old adage, “Don’t put all of your eggs in one basket”, then you understand the concept of investing your time/energy into a wide range of opportune endeavors (diversifying), thus reducing your overall risk and increasing the likelihood of success. The same is true for your financial resources. Let’s take Chipotle for example. A company with significant brand recognition, rapid expansion and consistent sales growth. A screaming buy, right? It would appear so on the surface but nobody could have predicted the 2015 E. Coli outbreak that sent the stock plummeting 60% into late 2017. This is an example of idiosyncratic risk, a type of risk you would take on if you only buy one stock. It is idiosyncratic because it is related to the unique circumstances of a particular company as opposed to the overall market. This type of risk can be significantly reduced through diversification; spreading your financial exposure across various companies. If one stock is down, another is up and your overall loss is reduced.
The Food & Beverage Sector as a whole performed relatively better during the same time period that Chipotle lost 60% of its value. The lesson here is that if you do have a strong opinion about a particular stock, try getting exposure to the broader sector or industry so that you’re not putting all of your financial eggs into one basket. The best way to do this is through an Exchange-Traded Fund, otherwise known as an ETF. Simply put, an ETF trades just like a regular stock, but instead of representing shares of one company, it represents the shares of a basket of stocks in a related industry, geography or strategy. So, if you have a strong feeling about the Food & Beverage sector, you could buy PBJ, the food & beverage sector ETF. Through this stock, you own a small share of 30 companies in the fast food sector that, when combined can create an overall profit, rather than owning just one and risking major volatility. If Chipotle suffers another E. Coli outbreak, sending the stock plummeting, you will be protected based on the fact that you own a share of a variety of companies.
Misconception #2: The Trend is your friend……until it ends
A “cult stock” has a disproportionate share of media attention and an extremely loyal investor following even though the company may not have the underlying performance to back it up. When we see everybody else confidently buying a certain stock, our human nature drives us to want to participate. While it can be tempting to purchase these stocks in fear of missing out, it is best to avoid these types of purchases. The problem isn’t the investment itself, but the thesis behind the investment. Buying a stock because you see the chart continue to go up and because everybody else is buying it can lead you down a bad path.
Take Bitcoin, for example. While the cryptocurrency began trading in 2010, it gained media notoriety and, eventually a cult following in late 2016-early 2017. People poured money into Bitcoin based on its popularity and because they saw the price rapidly rise and did not want to miss out. Bitcoin soared in a short amount of time, eventually reaching a price of ~$14,000 by early 2018. People continued buying at this level, assuming it would continue to rise as it always had. This price would be the highest that Bitcoin traded. It’s crash was as rapid as its rise and it traded at $3,000 just a year later.
The lesson is that the trend can be your friend and your worst enemy. Stocks can rapidly rise in value when everybody loves them and crash just as rapidly when everybody decides they are done with them. Unsurprisingly, we’ve not heard much in the media about bitcoin since its crash.
Buying because everybody else is buying is generally a poor investment thesis. You don’t have to be an expert, but there are some key objective metrics to consider before buying a stock. All public companies are required to file their financial reports to the SEC on a quarterly and annual basis. These reports (known as the 10Q report for quarterly reports and the 10K for annual reports) highlight the financial health of the company and include data on revenue, expenses, sales, debt levels and much more. They can be found at the company’s website, under the “Investor Relations” tab. To name a few metrics you should look out for:
1.) Earnings growth. Look for companies that are growing their profits consistently quarter over quarter and year over year.
2.) How much debt a company has relative to cash. Companies with a solid user base, which generates consistent profits, do not need to take on excess levels of debt. If a company carries extreme amounts of debt relative to the actually cash it has on hand, that could be a sign to stay away
3.) Price-to-Earnings Ratio. What is the price of the company’s stock relative to the earnings it generates? If this number is high, the stock may be “overvalued”, meaning it is expensive. If this value is low, the stock may be “undervalued” and may be relatively cheap.
There are some subjective measures to consider as well. For instance, how has the stock performed historically versus its peers in the same sector, what industry is the stock in and how is the overall industry performing. Energy companies, for example, may perform worse in general when oil demand and gas prices are low. How well is the company positioned for a downturn in the economy. Some stocks have thrived during the pandemic. Zoom Video Communications is up 142% since the beginning of the year as the shift to remote work has led to a surge in demand for the platform. Stocks such as Amazon, Apple and many other tech companies are considered to be “recession proof”. The majority of their operations are online, and therefore remain unaffected by the lack of foot traffic and disposable income. Contrast that with stocks in the retail and travel sectors, which are considered to be heavily cyclical as they are dependent on the overall economy. When people have more disposable income, they spend that income on discretionary items such as clothes, vacations etc. When the economy is faring poorly, people spend on necessities but have less dollars in their pockets to spend on frivolous items. In essence, how you blend these metrics to determine suitable investments is completely up to you. The salient point is that you should always employ some form of analysis before buying into the hype of a stock.
To conclude, remember:
Make sure to diversify your stock investments across industry verticals. One way to avoid putting all of your financial eggs into one basket and gain exposure to a variety of companies is through the use of ETFs. Avoid herd mentality in your investment decision. Instead, integrate some of the objective and subjective metrics I outlined to develop an investment heuristic that is suitable for you.
Be encouraged that you only need to be right about 50% of the time. If you make a bad investment choice, it’s ok. We will all make them and, as long as we are smart with our investments, recovery over time is inevitable. Hopefully these tips help you to avoid some common mistakes. But even so, don’t focus unnecessarily on the mistake. What’s more important is learning from that mistake, adjusting your approach, and maintaining confidence in your portfolio.
