Please note that tax, investment, pension and ISA rules can change and the information and any views contained in this article may now be inaccurate.
Creating a strategy for a beginner stock investor
Investors need to have a clear goal as this helps to define the type of investments to be considered for a portfolio.
For example, are you investing over several decades for a pension pot to draw on when you stop working or are you approaching retirement and need to assess your options now? Is regular income going to be important to you in the future or are you keen to build capital?
We’ll now explore some simple types of investment strategy, what helps create value for investors, and some warning signs that might signal the destruction of value.
WHY STOCKS GO UP
To state the obvious, investors want to buy stocks that go up. There are countless factors that can influence share prices, such as consumer spending, business confidence and economic growth. The most important factor is how well the company is performing.
When a business is doing well investors want to own it, so demand pushes the share price higher, and vice versa. People talk about ‘buying low and selling high’, and while this may sound awfully simple, it’s very hard to do successfully.
WHAT BUY LOW, SELL HIGH MEANS
The idea behind buy low, sell high relates the nature of stock market cycles. Stock prices fluctuate based on many factors; world events, interest rates, consumer spending, business confidence, a company’s growth and much else.
The price of a stock is based on the supply and demand among investors at that moment in time. As the environment changes, so does the stock price.
TIMING THE MARKET
The strategy behind buying low and selling high relies on trying to time the market. Buying low means trying to determine when a share price is out of favour and buying in the hope of it going up as conditions improve for the company.
Conversely, selling high relies on figuring out when a share price has hit its peak. Once stocks have hit their maximum value, investors sell their shares and reap the rewards.
This looks like a good idea, on paper, but it essentially requires an investor to ‘time the market’, or in other words, predict the highs and lows.
Anyone who doesn’t want to risk getting their timing wrong should really consider tracker funds or exchange-traded funds which merely track the performance of the market, so no timing is required.
An alternative is to buy a fund managed by someone who is doing all the stock research and making a judgement on when to buy and sell.
THE DIY ROUTE
For those happy to do it themselves, there are various valuation tools that can help such as the price-to-earnings (PE) ratio. This compares the share price to a company’s earnings.
In theory, you buy when it looks cheap and sell when it looks fair value or expensive.
We’ll go into more detail on what the PE is, what it tells you and how to calculate it in a future installment of our First-Time Investor series. We’ll also look at other valuation methods.
It is important to stress that while you may have some success with picking stocks, it is extremely hard to get it right all the time. Even the highest paid fund managers with decades of success won’t get everything right.
VALUE INVESTING AND GROWTH INVESTING
There are countless methods of stock picking that analysts and investors employ, but virtually all of them are one form or another of the two basic stock buying strategies of value investing or growth investing.
Value investing involves finding a stock that is trading below its intrinsic value. Essentially it means identifying a company that should be valued at a higher price if it fixes a problem or once the market recognises its true worth.
Growth investors seek out companies with high growth potential over the long-term, hoping earnings improvement will fuel a higher share price over time. They are usually less concerned with dividend income and are more willing to risk investing in relatively young companies. Technology stocks, because of their high growth potential, are often favoured by growth investors.
GOOD AND BAD TRAITS
There are some key characteristics of good companies and red flags for ones to avoid. The positives include things like consistent performance over several years, strong cash generation, manageable borrowings plus aspects like a proven management team, best-in-class products and growth potential within its markets that stretch long into the future.
Too much debt is one of the big red flags. Repaying large borrowings can put too much pressure on a company’s overall finances, starving the business of vital investment. In bad cases it can force companies to raise fresh funding, usually at the expensive of shareholders.
We will explore investment styles, company qualities and red flags each in more detail in future First-Time Investor articles.
Next time we look at the various places you can find stock ideas and the pros and cons of internet bullet boards and social media channels for an investor.