Investing Money

An Introduction to Investment and Personal Financial Planning

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How to Pick Stocks

If you're going to choose your own stocks, a few words of advice:

1) Minimize trading fees by shopping around brokerages. Online brokers are usually cheapest by some way. Be sure to choose an execution only service. Stocks may be held on your behalf in the broker's nominee account. Check if there is any periodic management fee associated with this that may negate the bargain dealing charges. In some cases the management fee only applies on accounts in which few trades take place. Interpret the small print with regard to your likely trading style.

2) Minimize trading fees by avoiding churning (buying and selling with high frequency) your holdings. If you are an investor (rather than a trader) you shouldn't need to continually re-evaluating your portfolio. So long as you choose high quality stocks, and these should form the core of your holdings, your portfolio should evolve gradually rather than in dramatic jumps.

3) Reduce risk through diversification. How many stocks you can hold depends to a degree on how much you have to invest. But if you can't afford holdings in at least half a dozen stocks you should stick with tracker funds. Your holdings should be sufficiently different to one another so that conditions that adversely affect one should have much less effect on the others. This can be achieved by distributing your choices among different sectors; eg real estate, utilities, transportation, retail, leisure...

4) Know the risks, understand beta. The beta of a stock is a numerical measure of the degree to which (historically) its price moves in relation to the market. A beta of 1 means the stock moves in line with the market. A beta less than 1 indicates less volatility than the market, ie you'll lose less in bad times but gain less in good. A beta of more than 1 means the opposite, you'll gain more than the market when it rises, but also lose more when it falls. The higher the beta, the higher the risk (the higher the potential gains - or losses). You may care to match the beta of your holdings to your personal attitude towards risk. You may also wish to balance a few high beta stocks with a core of lower betas.

The Economic Cycle

Economies tend to move in cycles. Being able to judge at what stage in the cycle an economy is at is a valuable input to formulating an investment strategy.

Two related indicators of where and economy stands in its economic cycle are the inflation and interest rates. In general these move as follows:

A sluggish economy is boosted by interest rate cuts. This stimulates growth but also causes inflation to rise. As the economic growth rate rises to unsustainable levels the interest rate rises to bring a controlled slowdown and reduce inflation. Economic growth rates and inflation slow, before the cycle starts again.

When interest rates are falling, stocks, real estate and bonds (paying fixed interest) make the best investments. As inflation rises, stocks and real estate will best protect your money's buying power along with price-index linked instruments. When the interest rate is rising, cash is the best place to both gain from higher returns while sheltering your funds from being squeezed elsewhere. A period of falling inflation favors cash and bonds with the astute investor being ready to return to stocks and real estate.

Further Reading