A bull market may give you a heady feeling and trick you into believing that you are an astute stock picker. Of course, it always sounds glamorous to say that you invest in stocks. But that doesn't mean you should.
Author, columnist, stock analyst and financial educator Brian Feroldi explains the basics in Why does the stock market go up? Over here, he answers three questions in this regard that should give you an honest assessment of whether or not direct stock investing is your cup of tea.
Q1. Should small investors buy and hold individual stocks?
If the average person invests into index funds, I'm extremely confident that they will do very well over long periods of time. That is the right choice for 98% of the population. However, there that 1% to 2% of the population that are just interested in business and stocks. And if they have the inclination and time to do the research and buy stocks--I think that that is a viable strategy for building long-term wealth.
There's a lot of skills that you need to develop if you're going to go through the process of picking your own stocks. You need to study accounting and history, you should be able to think through business models and think through risks, you have to study your own psychology and your own behaviour. It's worthwhile to look at some of the greatest investors of all time and really learn what they did. That is a whole lot of effort that people have to go through if they want to buy individual stocks and try and outperform over the long term.
The number-one characteristic that you need is interest in doing that, because that is a time-consuming process. And for most people, the idea of digging through annual reports or listening to a conference call would just bore them to tears. If you want to pick your own stocks, you do need to put the time and energy into learning how to do it correctly. And you have to be interested in it enough to do it more than you'd want to do any other activity.
So, while I don't think the effort of picking your individual stocks is worthwhile for everybody, for a very small percent of the population, I think it's a perfectly viable strategy.
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Q2. What is the checklist to have when you invest in stocks?
Make a list on every business attribute that would make a company appealing to you to invest in. I've done this process for myself, and I came up with 25 attributes that I am attracted to. For example:
- A strong balance sheet
- Positive free cash flow
- High returns on capital
- A business with a moat that is wide and expanding
- A founder-led business
- Happy employees
- A stock that's already beaten the market
Now make another list of the attributes that you don't want to see in a business. For example:
- Accounting problems. If I can't trust the numbers, how can I possibly trust anything else about the business?
- When a business gets an outsize portion of its revenue from just a small number of customers.
- When a company relies on interest rates, or commodity prices, or a strong stock market to succeed.
- When there's high levels of dilution through stock-based compensation.
I made these two lists on positive attributes and negative attributes and ranked them from most important to least important. From there, I assigned a very simple weighing system. Any business that I come across, I run through my investing checklist and I come up with a simple scoring system that tells me how strong of a match is this company for my investing needs.
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Q3. Do individual investors have an edge over fund managers?
The data is very clear that most mutual funds underperformed the index over long periods of time. So, why would an individual have any better luck at that? I firmly believe that individual investors have a structural advantage over mutual fund managers.
Individual investors are investing their own capital and have no career risk. They don't have to explain or justify why they own ABC stock, or why ABC stock is underperforming to anybody else. And because they're investing their own capital, and they're not going to fire themselves, they can truly focus on longer term horizons when they're making an investment.
If you look back at any of the best-performing stocks of all time, all of them without exception went through periods when their stock went down dramatically. Amazon in the wake of the 2000 crash, peak to trough fell 92%. That is a whole lot of pain for Amazon investors. And if you're a professional money manager, and you're having to hold through that, your investors are going to be pointing at that and saying, “Why do you own this stinker?” It's really hard to justify to other people why you own a stock. However, when you're investing your own money, and you're picking your own individual stocks, you can truly ignore that short-term volatility and invest with the long-term in mind.
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The above has been taken from Brian Feroldi's conversation with Morningstar's director of personal finance Christine Benz, and chief ratings officer Jeff Ptak.