Evaluating Stocks for Your Portfolio
The stock market and its potential for risk intimidates many people. Nonetheless, a well built stock portfolio, over time, will outperform other investments. It is possible to build a stock portfolio yourself, but even if you work with a broker, understanding your goals as well as the nature of the market will help build a successful investing strategy. Below are steps on how to build a stock portfolio and how to evaluate stocks to build your portfolio with.
Method 1 of 2: Portfolio-Building Strategies
1 Commit to investing over the long term. It is possible to make "a killing in the market" by making a lot of money on a stock in a short period of time, but that sudden gain can be wiped out by an equally sudden loss. A sustained presence in the market is more likely to pay over time than trying to make a quick buck.
As part of investing over the long term, determine how much money you won't need to touch for 5 years or longer and set that aside for investing. Money you'll need in a shorter period of time should be invested in shorter-term investments.
2 Understand the different kinds of stocks. Stocks represent an ownership stake, or share in the company that issues them. The money generated from the sale of stock is used by the company for its capital projects, and the profits generated by the company's operation may be returned to investors in the form of dividends. Stocks come in 2 varieties: common and preferred stocks. Preferred stocks are so called because holders of these stocks are paid dividends before owners of common stocks. Most stocks, however, are common stocks, which can be subdivided into the categories below:
Growth stocks are those stocks projected to increase in value faster than the rest of the market in general, based on their prior performance record. They entail more risk over time but offer greater rewards in the end.
Income or value stocks are those that pay better dividends than other stocks. This category can include both common and preferred stocks.
Blue-chip stocks are stocks that have performed well as either growth or income stocks for a long enough period of time that they are considered safe investments. They may not grow as rapidly as stocks designated as growth stocks or pay as well at a given time as stocks designated as income stocks, but they can be depended upon for steady growth or steady income. They are not, however, immune from the fortunes of the market.
Defensive stocks are stocks for companies whose products and services people buy, no matter what the economy is doing. They include the stocks of food and beverage companies, pharmaceutical companies and utility companies.
Cyclical stocks, in contrast, rise and fall with the economy. They include the stocks of such industries as airlines, chemicals, home building and steel manufacturers.
Speculative stocks include the offerings of young companies with new technologies and older companies with new executive talent. They draw investors looking for something new or a way to beat the market. Most of these stocks don't do well.
3 Develop an investment strategy that meets your goals. Decide what type of stock portfolio is most important to meet your overall financial goals. If making a lot of money over time is important to you, you'll want to build a stock portfolio of largely growth stocks, with some blue-chip and income stocks and possibly either a few well timed cyclical stocks or well researched speculative stocks. If you need to earn a continuing income from stocks, you'll want to build a portfolio composed primarily of income stocks, with some blue-chip and defensive stocks for balance.
Understand that your financial goals may change over time and adjust your portfolio over time. Generally, the younger you are, the more risk you can take and may be better served with a growth-oriented portfolio, while the older you become, the more you'll need a source of income and may be better served with an income-oriented portfolio.
4 Diversify your holdings. Regardless of whether you pursue a growth-oriented or income-oriented strategy, you should rely on more than 1 or 2 stocks to make up your portfolio. Investing in multiple stocks spreads your risk over several companies and possibly several industries and classes of stock, depending on how you build your portfolio. Ideally, poor performance by 1 or 2 stocks will be offset by significant gains in the other stocks.
One way to ensure diverse holdings is to invest in stock mutual funds, either in combination with or in place of direct stock ownership. Mutual funds are often good for new investors to the stock market, giving them a chance to learn the ins and outs of the market as they reap the benefits of investing.
5 Invest regularly. Just as saving regularly can build your bank balance, investing regularly can build your portfolio over time. Buying stock or mutual fund shares on a regular basis lets you take advantage of dollar cost averaging, which lets you buy more shares per dollar during times when stock prices are low and take advantage of the increased value when prices are high.
One type of portfolio in which you can invest regularly without a broker's assistance is a direct investing, or DRIP, portfolio. DRIP portfolios usually require a smaller initial investment than most brokerage offerings because there are no broker fees, and they let you start with a smaller number of stocks that you can research before buying and track afterward.
Method 2 of 2: Evaluating Stocks for Your Portfolio
When looking at P/E ratio, figure the P/E ratio for the stock for several years and compare it to the P/E ratio for other companies in the same industry and for indexes representing the entire market, such as the Dow-Jones Industrial Average or the Standard and Poor's (S&P) 500
2 Look at the stock's book value. The book value, or shareholders' equity, is the theoretical amount that stockholders would be paid for each share owned if the company went out of business. Stocks that sell close to or below book value are considered cheap stocks.
Look at the reasons for the stock selling near or below book value as well as the actual price. It may mean the stock is undervalued and is a bargain, or it may mean that the company is having trouble.
3 Look at the return on equity. Also called return on book value, this figure is the company's income after taxes as a percentage of its total book value. It represents how well the shareholders profit their investment in the company's success. As with P/E ratio, you need to look at several years' worth of returns on equity to get an accurate picture.
4 Look at the total return. Total return includes earnings from dividends as well as changes in value from the price of the stock and provides a means of comparing the stock with other, non-stock investments.
5 Evaluate the debt-to-equity ratio. This ratio is the company's book value divided by its debts. The more money the company pays in bond interest or lines of credits with banks, the less it can invest in its own future, protect itself from downturns or pay dividends. Debt-to-equity ratios vary in different industries and should be compared against other companies within the same industry to gauge whether the ratio is acceptable or excessive.
6 Observe the stock's volatility. How much the stock's price has changed in the past is a good measure of how likely it is to change in the future. One measure of volatility is beta, which compares the fluctuations of an individual stock against those of an index such as the S&P 500. A beta of 1.0 means that the stock fluctuates as the index does; a lower beta means it fluctuates less and a higher beta means it fluctuates more.
These 6 factors are known as a stock's fundamentals, and evaluations using these factors are called fundamental analysis. Another way to evaluate a stock is through factors such as previous price changes, the ratio of advancing to declining stocks and other related statistics. This form of analysis is known as technical analysis.