Are you thinking about investing in stocks? Investing money into stocks can bring you large financial returns over an extended period of time. It’s important to note, however, that while these types of financial gains may seem enticing, they come also come with inherent risks as well.
To minimize your risk, it is important to:
- Educate yourself on how to make stock investment decisions intelligently and with confidence
- Find resources that will help you properly evaluate a stock before you buy it
By mastering both, you will avoid common pitfalls and mistakes when it comes to investing.
Here are 6 key things to consider when investing in stocks:
Determine Your Risk Profile
No matter what asset class you choose, all investments involve some level of risk. After you figure out your appetite for risk, you will be able to determine whether investing in stocks is right for you.
One thing to consider is whether you are comfortable in potentially losing all of your principal investment. Although stocks can lead to a larger return in the long run, this risk makes stock investments unsuitable for individuals with a low risk tolerance, as well as those who have a short-term investment horizon.
Stock Investment is Just One Option of Many Asset Classes
Related to the previous point, if your goal is to produce investment income then you might consider stocks with a large dividend payment, or even a completely different investment such as cash and bonds.
If you want to have a direct impact on your investment return, (such as renovating an investment property) then stock investment might not be suitable for you either, since management decisions are not in your control.
Learn About the Companies That You Are Considering Investing In
When you invest in stocks, you are not just buying the stock itself. You are buying into the company and the belief that it will be successful and profitable in the long term.
Therefore, it is important to do your homework on these companies before putting your money at risk. Here are 4 ways to determine if a company is fundamentally sound:
- Earnings – Generally, this number should be higher than the previous year. A 10 per cent increase is a good benchmark.
- Sales – Sales numbers should be higher than the previous year.
- Debt – The amount of debt in the company should be lower or the same than the previous year. It should also be less than the company’s overall assets.
- Equity – Like sales, the equity value should be higher than the previous year.
Take A Look at the Company’s Financials
You don’t have to be an expert at security analysis to determine if a company has a sound financial base. Here are key financial measures that you can check:
- P/E Ratio – This ratio should be under 20 for stocks with a large market cap. For all other types of stocks (such as small cap, growth and speculative) the ratio shouldn’t be higher than 40.
- Price-to-Sales Ratio – It is favorable to have this ratio as close to 1 as possible.
- Return on Equity – As a guideline, this ration should be increasing by 10 per cent per year.
- Earnings Growth – The growth of a company’s earnings should be 10 percent higher than the previous year, and should be maintained over several years.
- Debt-to-Asset Ratio – The amount of debt should be less than half of the company’s assets.
Avoid Investing All Your Money In One Stock
Investing all of your money in one stock is a very high-risk strategy. Although you may make a large financial return if the stock rises, the risk of losing all your money is just as high.
By spreading your stock investments among different companies and industries, you will be able to diversify, which in turn, will lower your risk of losing everything.
Consider Mutual Funds
If you’re unsure of how to invest in stocks, or don’t have the time to do the homework, consider investing in mutual funds.
Mutual funds are a collection of investments, managed by a professional fund manager. Although they can contain a variety of investments (such as bonds, real estate, foreign currency), there are mutual funds that invest exclusively in stocks.
Investing in stocks can be a volatile, yet financially rewarding experience. By taking the above 6 points into consideration, you will be better prepared to handle the challenges of making stock investments and reap the rewards of intelligent investing.