The stock market is a vast universe—about 41,000 publicly listed companies worldwide with a total market capitalization of $117 trillion, as of early 2022. There are so many choices. The challenge for many investors looking to invest in stocks is where to begin.
4 Things to consider when investing in stocks
Investors who plan to make stock investments might consider the following.
1. Risk tolerance
Risk tolerance is a measure of where on the risk spectrum the investor lands. Someone with less appetite for big swings in market value may prefer stocks of more established companies with moderate growth. A more aggressive investor, willing to accept some losses in pursuit of larger gains, may prefer growth stocks. These are stocks of younger companies in industries with faster rates of revenue growth but little or no earnings. High-risk investors are looking for the company with the potential to become the next Apple, Amazon or Tesla.
2. Investment time horizon
Investment time horizon is a measure of where on the time spectrum the investor fits—are they young or old? How long does the investor expect to hold the stocks? Short-term investments generally are those held less than one year. Beyond that, investments are regarded as long-term.
The time horizon of holding a stock has two important implications: Capital gains from selling long-term stock holdings are taxed at a lower rate than regular income, while short-term stock gains are not. And the longer an investment is held, the more time it has to recover from any market slumps and grow through compounding of returns.
3. Personal goals and values
Does the investor want to retire early, or keep working until normal retirement age or even beyond? Do they want to save and invest for a child’s college education? Are there any ethical or political considerations, such as avoiding oil, casino, tobacco and liquor companies? Does the investor want a global portfolio, or only U.S. stocks?
Diversifying, or avoiding concentration in any one stock or industry, generally lowers the risk of price volatility and losses; concentration raises risks. An oft-cited rule of thumb is that no single stock should account for more than 5% of a portfolio.
4 Types of investment strategies
An investor’s goals, risk appetite and time horizon can influence which strategy to use in selecting stocks. Investors usually fall into one of the following categories.
Investors who want to generate income while holding stocks might gravitate to stocks of dividend-paying companies. Stocks with consistent dividends tend to be older, established companies in non-cyclical industries—those that cruise through the economy’s up-and-down cycles. Coca-Cola and Procter & Gamble are two such examples. Utilities and real estate investment trusts also pay a high proportion of their earnings as dividends.
2. Wealth preservation
Investors who have already built wealth may be now more focused on keeping it. Their risk appetite has abated after their wealth-building years, so their investments are broadly diversified. In addition to lower-risk income stocks, they may prefer bonds and cash-equivalent securities such as certificates of deposit.
3. Capital appreciation
Capital appreciation is merely market jargon for a rising stock price. Investors focused on capital appreciation—buying low and selling high—may gravitate to stocks with the highest earnings growth, or sales growth in the absence of earnings. Growth stocks often are volatile, with big price slumps that take a longer time to recover from.
It may not exactly be gambling, but speculation is the riskiest approach to investing. The company could become the next Apple or Google, but odds are it will flop. This kind of investor should be prepared to lose it all.
Companies with publicly traded shares typically are classified in one of two ways, based on investors’ expectations for their businesses: growth or value.
Growth investing generally focuses on younger companies in new or evolving industries. Their price-to-earnings (P/E) ratio may be high or they may not yet be profitable, but investors see potential for huge success with an interesting new product, technology, patent, or business model. Examples include Tesla for electric cars, and Regeneron Pharmaceuticals for cancer drugs, eye-disease drugs, and monoclonal-antibody treatments for viruses including Covid and Ebola.
Value stocks are considered bargains, with low P/E ratios—the kind of stock that legendary investor Warren Buffett seeks out. Their stock price may even be below the company’s intrinsic value—the net value of its assets after subtracting liabilities. Sales and earnings in these companies may have slowed but they produce steady cash flow and high dividend yields, and they are less volatile than growth stocks. Makers of consumer staples and grocery chains are often viewed as value stocks.
Analyzing stocks before investing
Research and analysis can help an investor make an informed decision. There’s a wealth of information to be found in financial publications,websites, analyst research reports, and company regulatory filings.
Stock analysis involves a combination of two methods: fundamental and technical analysis.
Fundamental analysis involves examining a company’s business model (what it sells and how it makes a profit), its sales and profit trends, and its financial and operating ratios such as price-to-earnings and debt-to-equity ratios. Fundamental analysis includes an estimate of a company’s future value based on its projected cash flows and dividends.
Instead of looking at a company’s performance, technical analysis uses charts to spot recent patterns or trends in a company’s stock price to try to determine which way it may be headed in the coming days, weeks or months. In contrast to fundamental analysis and its focus on a company’s potential or long-term future stock price, technical analysis helps investors decide if the current price is a good buying opportunity.
Investors may also consider these two contrasting approaches to researching and analyzing stocks:
- Top-down analysis. The investor starts by reviewing the broad economic environment—is the country's economy growing or shrinking? Do other regions have stronger economies? Are interest rates rising or falling? After an initial macroeconomic review, the investor considers various classes of assets such as stocks, bonds, commodities, and real estate for suitability. Selecting the stock market, the investor then analyzes and compares sectors and industries, and finally chooses specific stocks. A top-down approach generally favors a broader array of stock investments across sectors, in a diversified portfolio.
- Bottom-up analysis. The investor targets individual companies first, examining their financial and operating ratios, comparing them against other companies in the same industries, then comparing industries and sectors. A bottom-up approach tends to focus on trying to pick winners, in a concentrated portfolio.
Stock portfolio strategies
Besides deciding how to analyze and buy and sell stocks, investors must also decide how to manage their stocks. Do they have the time and attention to closely monitor their holdings, or would they rather put their investments on auto-pilot? These approaches can be broken down as active versus passive management.
- Active management. This refers to the hands-on strategy of creating and maintaining a portfolio of stocks, relying on the investor’s research and analysis or that of a professional manager to pick stocks. An active strategy may involve more frequent buying and selling, known as portfolio turnover, as the investor seeks returns higher than broad market averages. Because active management requires more time and effort, there will likely be expenses in the form of fees to pay for trades, research and a portfolio manager.
- Passive management. The opposite of active management, this approach focuses on investing in index funds or exchange-traded funds (ETFs), leaving money in these funds and not actively checking their performance. Computer programs often establish and manage the investment process with little or no human involvement. Passive-investing strategies have become very popular as their returns have been proven to frequently exceed active-investing returns.
Alternatives to picking individual stocks
Some investors may find it easier to put their money in instruments that do most or all of the stock picking for them. Many types of funds, as well as automated accounts such as robo-advisors, do this.
- Index funds and ETFs. The biggest index funds and ETFs track widely used market benchmarks, such as the S&P 500 Index and Nasdaq 100 Index. Investors can easily follow their portfolios simply by looking at the indexes; for example, if the S&P 500 declines by 1%, their index fund also declines by 1%.
- Mutual funds. Mutual funds usually are actively managed to one degree or another, so they have higher expenses than index funds. Funds range from those that focus on the total stock market, to large-cap or small-cap stocks, to specific sectors, industries and regions. Some ETFs also are actively managed because they allow the fund manager to make minor deviations from the index’s composition of stocks, in seeking a marginal improvement over the index’s return.
- Robo-advisors. These are computer-driven financial planning services to create an investment portfolio. Investors answer a series of questions online about their financial circumstances, goals, and the robo-advisor uses the answers to suggest investment options including automatic investment plans, for instance a monthly $200 contribution to the robo account. Most robo-advisers also use portfolio rebalancing technology to keep investors within a range of suggested allocations of stocks and other assets.
The bottom line
Choosing stocks for appropriate investment can be a daunting task. Individual investors can do it if they’re willing to devote the time and effort. As an alternative, some investors delegate the responsibility of making many of the decisions to a professional portfolio manager.