Deciding how to invest is a lot like shopping for a car, but a lot more consequential. You can start by understanding your personal needs and style. Then you can consider different models, comparing choices based on their price and potential performance. Investment decisions deserve a similar but even more robust analysis. For many, evaluating investments might feel as natural as shopping on a car lot, especially if you’re doing it for the first time. But, by learning the basics, you can figure out what to look for, and what to potentially avoid.
Whether you’re buying a single stock or building a diversified portfolio, smart shopping can have an impact on your portfolio’s performance. So how do you tell a reasonable investment from a total lemon? Well, there are no guarantees, but there are some ways to increase your chances of making an investment that supports your goals. Here are four steps to consider when analyzing a potential stock investment:
1. Go in with a plan
Just as you choose a car to fit your lifestyle, investments should support your goals. Your plans will inform how long you want to keep an investment, and how much risk you’re willing to take on. Certain investment goals may remove some more volatile investments from your consideration. For instance, if you need money in the short-term (e.g., to pay off credit cards or pay tuition), investing in volatile assets might put that money at too much risk for your comfort. Stock prices can fall quickly, taking your plans for the money along with them. That said, (while past performance is no guarantee) stocks have also been one of the better opportunities to achieve growth over the long haul. Holding stocks for longer periods of time (10-plus years) generally reduces the risk of loss, which can make them helpful to hold to support long-term goals, such as a home purchase, a child’s education, caring for parents, or retirement. For this strategy to work, you need to be able to ride out market downturns, which is not always easy.
As you decide how much risk you can handle, you might consider how your investments are balanced. In other words, what percentage of your portfolio is allocated to each type of investment? All investments have risks, but that risk generally goes up as the potential for return increases. That’s why some investors make room in their portfolios for a portion of typically lower-return investments, such as bonds, to help balance out higher-risk, potentially higher-return investments like stocks.
2. Know the different makes and models
Just like the various vehicles at a dealership, every stock is different. They can vary in size, purpose, and of course, price. It’s up to you whether you want a soccer mom van or a sports car—or something in between. When you look at a stock, you might consider its market cap, the sector it belongs to, and where it could fit into your portfolio. You can also consider what makes it attractive. Does the company pay dividends? Does it look poised to grow?
Here are some key filters that can help you categorize stocks and size up their potential:
Size: When you go car shopping, you might think about whether you want a SUV or a sedan. Likewise, many investors think about a company’s size. One common measure of a company’s size is its market capitalization (aka “market cap”). This is the value of the company if you multiply the total number of outstanding shares by the company’s current share price. For example, if there were 30 shares in Eric’s Electronics and the market price was $4, the company would have a market cap of $120 (30 shares x $4 per share = $120 market cap).
Small-cap companies are generally valued between $250 million and $2 billion, and mid-caps are valued between $2 billion and $10 billion. Large-cap companies are those valued at $10 billion or above. Sometimes though, market cap is based more on perception than a company’s fundamentals. That’s because some investors value stocks based on their intrinsic value, while others approach them based on their apparent popularity, or market sentiment. With that in mind, companies frequently share certain similarities at different stages of growth. Small-cap companies are often unproven – Many show potential or could be acquisition targets, but they also face growing pains. For instance, can they expand beyond their existing customer base? Are they under pressure from incumbents or regulation? Small-cap companies could eventually become mid-cap or large-cap companies, but they could also fail. It’s also fully possible that a small-cap company could remain a small-cap company. By contrast, large-cap companies tend to be more stable, with management experience and cash on hand – Both can help weather the challenges that arise from competitors and sustain performance. As a whole, large-cap companies are more likely to pay dividends (more on that below). You can find many large-cap stocks in the S&P 500 Index, a collection of some of the largest publicly-traded companies in the US.