Strategies for Stock Investing

Average completion time: ~9 minutes

In this article, you will learn:

Lesson 2: Strategies For Stock Investing

What is an investing style and why do I need one?

Finding the right companies to include in your stock portfolio is not an easy task. Even knowing where to start can be difficult -- there are currently over 2000 companies listed on the New York Stock Exchange and over 3000 companies listed on the NASDAQ. Most investors therefore choose an investing style that suits their own financial situation and start looking at the specific types of companies that would let them meet their individual financial goals. Things that go into creating your ideal stock portfolio include your investment timeline, your own personal risk tolerance and even how much time you want to spend managing your stock portfolio.

Choosing an investing style #1: How much should I invest?

There are no hard and fast rules in figuring out how much of your money you should invest in stocks, but there are a few simple guidelines that can make stock investing significantly safer and less risky.

  • Rule One - Never invest what you truly can't afford to lose:
This is just common sense. If you have $50,000 in total savings, don't put all $50,000 in your investment portfolio. Keep $10,000 to $20,000, or the equivalent of one or two months worth of living expenses aside at all times. No one can predict the future, and a small savings nest egg is one of the only certainties you can have. Obviously, the other extreme of keeping all your savings in cash is almost worse because inflation will eat away at your savings and leave you poorer than when you started.

  • Rule Two - Find the risk-reward balance:
Now that you know how much you want to put in your overall investment portfolio, you need to figure out how much of that will go into stocks. Remember from Lesson 1: What is the Stock Market? that stocks have vastly outperformed bonds, savings and precious metals like gold over the long run. Your investment timeline is very important. Obviously, if you're young (say, under 40-45 years old) and you have up to 20 years or more to invest your money and ride out any short term swings, you can invest a significant amount of your savings in stocks. You could invest anywhere from 60-80% of your money (excluding the safety nest egg) into stocks and slowly move that money out into cash and safer assets over several years as you approach retirement.

If you're planning to retire in the next few years, obviously some of your assets need to be in safer, less volatile assets like bonds and gold. However, with life expectancies in the developed world reaching close to 80 years, realize that even if you are a recent retiree, you will still need your wealth to last you 20 years or more, and that means your investment returns need to consistently be outpacing inflation. Therefore, continuing to invest anywhere from 20-50% of your money in stocks still makes great sense, especially compared to just putting your money into a traditional savings account.

  • Rule Three - Do what feels right:
Again, remember that at the end of the day, how much you're comfortable investing in the stock market is a personal decision that requires serious thought and consideration of your own risk tolerance and financial situation. Consider starting out with smaller investment amounts and then increasing your investment as you learn and gain real experience in the stock market.

Rules of Investing, How much to invest in stocks

Choosing an investing style #2: What are Large, Medium and Small Caps?

In Lesson 1: What is the Stock Market?, we spoke briefly about market capitalization, or the size of a listed company. While it is obvious that a company of any size could do well or poorly on the stock market, there are general trends for different sized companies that can help you make informed investment decisions. In the investing world, small companies (usually under $1 billion in market capitalization) are known as small caps, medium sized companies (usually $1 to $10 billion in market capitalization are known as mid caps, while the largest companies (greater than $10 billion in market capitalization) are known as large caps. Large, established companies are also referred to as blue-chips.

These different sized companies offer quite different prospects. Small caps often generate their revenue from a couple of core products or are exposed only to specific, smaller markets. As lesser known companies, they may find it harder to secure loans from banks, or they may attempt to grow too quickly and therefore take on more debt than they can handle. The risk of a small cap going bankrupt and taking your investment to zero is significantly higher than for a blue-chip with a long track record such as Coca-Cola (KO) going bankrupt.

On the other hand, small caps are often bringing new products to the market, with huge potential for their stock price if they are successful. While large companies are often happy with growth rates in the single or double digits, growing small companies can achieve astonishing growth rates. If you had bought $100 worth of stock in a small, growing technology small cap called Microsoft (MSFT) in 1986 and held onto it until 2010, your small cap investment would have grown to $23,574 over this time. These kinds of returns are simply not possible for large, established companies.

Large caps are far less volatile stocks, and the risk of bankruptcy in large, long running companies is significantly lower than for small caps. More importantly, large caps are often exposed to several markets for their products, including international markets, and their products are often better recognized. For example, based on their well recognized products and long track record of success, it would be very unlikely for a company such as Visa (V) or McDonalds (MCD) to suddenly drop dramatically in stock price. Large caps may also outperform their expected growth and grow in stock price rather quickly. As an example, Apple Inc. was considered a large cap with highly recognizable products in 2005, but still managed to grow its stock price four-fold from 2005 to 2010.

Mid caps obviously fill the gap between small and large caps. They often provide a significant track record that proves their ability to generate profits, but have greater potential for growth than mature large cap companies.

Small, Mid and Large Cap Stocks
While all of this knowledge is important to consider in determining your own investing style, it is important to realize that there is no reason to simply invest in one type of company -- instead, a blend of all three can help you achieve a balance between growth and stability. For example, if you would like to take on slightly more risk for the potential for greater stock price appreciation, you can simple shift more of your stock investing towards small caps and mid caps, while keeping a portion of your stock portfolio in more established large caps, all of which still promise significantly higher long run growth than savings or bonds. Investors with a shorter investment timeline who just want relatively stable growth in their wealth can simply put more of their money in large caps and less in small and mid caps.

Choosing an investing style #3: What are 'Value', 'Growth' and 'Income' stocks?

There are a few other key terms used in the investing community that refer to the general characteristics of certain stocks and the investing style around these types of stocks:

  • Value Investing -
Value investors look for companies that have stock prices that they believe are undervalued relative to their intrinsic value. They look at the assets, current earning, products, competitive advantages and other important characteristics of a company and try to determine if the stock market is pricing these things fairly. If they believe the stock market is undervaluing these assets or future profits, they will buy the stock and wait for the stock price to rise. Value investors focus less on trying to guess future earnings far into the future, and instead focus on the proven track records and existing assets and earnings of a company in trying to determine a fair stock price for a company. Value stocks usually have low Price-to-Earnings ratios, or PE's, because for one reason or another, the company is valued relatively lowly by the market relative to its recent profits. Value stocks may be of any size since any company may be undervalued by the market.

  • Growth Investing -
Growth investors focus less on the existing assets and earnings of a company, and instead look specifically at the earnings momentum and the products that a company offers. They look at the value of future earnings and focus on this large potential growth rather than looking at current earnings. They generally look for companies with high earnings growth, and these growth stocks generally have higher PE ratios because investors are looking at future growth rather than just the most recent earnings. Most growth stocks are small or mid caps since large caps have already gone through their growth stage and can no longer achieve the kind of returns that growth investors expect.

  • Income Investing -
Income stocks are stocks in companies that give out a large share of their profits out as dividends, which are regular payments made to distribute a portion of company profits to shareholders. Income stocks are usually large, established companies with significant cash flows that have less use for cash than smaller, growing companies.

Dividend Yield = Annual Dividends  Stock Price x 100

Dividend Payment = Dividends Declared by Company x No. of Stocks Held

For example, in the past year, Target (TGT) gave out dividends worth $1 a share, which equated to a 2.1% dividend yield (or 2.1 cents of dividends for every $1 of stock you own). This means for example, if you held 500 stocks in Target in the last year, you would have received $1 x 500 stocks = $500 in dividend payments. Dividends are a more consistent income stream for investors than stock price appreciation, and studies have also shown that companies who are forced to maintain good cash flow to fund dividends generally outperform companies that don't pay out dividends.