Stock selection is a very complex process and investors have different approaches. But it is wise to follow general steps to minimize investment risk. This article will summarize these basic steps for selecting high-performing stocks.
Step 1 Decide on the time frame and overall strategy of the investment. This step is very important because it will determine the type of stocks you will buy.
Suppose you decide to be a long-term investor, you will want to find stocks with sustainable competitive advantages as well as steady growth. The key to finding these stocks is to look at the historical performance of each stock over the past decades and perform a simple business S.W.O.T. (Strength-weakness-opportunity-threat) analysis on the company.
If you decide to become a short-term investor, you would want to adhere to one of the following strategies:
a. Momentum Trading. This strategy is to look for stocks that have increased in both price and volume in the recent past. Most technical analysis supports this trading strategy. My advice with this strategy is to look for stocks that have shown steady and smooth increases in price. The idea is that when stocks are not volatile, you can sustain the uptrend until the trend breaks.
b. Contrarian Strategy. This strategy is to look for extreme reactions in the stock market. Research shows that the stock market is not always efficient, meaning that prices do not always accurately represent the values of stocks. When a company announces bad news, people panic and the price often falls below the fair value of the stock. To decide whether a stock is overreacting to news, you should look at the likelihood that it will recover from the impact of the bad news. For example, if the stock drops 20% after the company loses a legal case that does no lasting damage to its brand and product, you can be sure that the market is overreacting. My advice with this strategy is to find a list of stocks that have recently dropped in price and analyze the potential for a reversal (via candlestick analysis). If the stocks show candlestick reversal patterns, I will review recent news to analyze the reasons for the recent price declines to determine the presence of oversold opportunities.
Step 2 Conduct research that ensures a stock selection consistent with your investment time frame and strategy. There are numerous stock screeners on the web that can help you find stocks based on your needs.
Step 3 Once you have a list of stocks to buy, you need to diversify them to give the highest reward-to-risk ratio. One way to do this is to perform a Markowitz analysis for your portfolio. The analysis will give you the proportions of money you should allocate to each stock. This step is very important because diversification is one of the free lunches in the investment world.
These three steps will get you started on your quest to consistently make money in the stock market. They will deepen your knowledge of the financial markets and give you a sense of confidence that will help you make better investment decisions.