A brief introduction on how to pick stocks

So even after reading my warning, and despite all the ease, simplicity, lower risks and very good returns of index funds, you still want to pick your own stocks, huh?  Read this first to see if you have the traits of a successful money manager.

I recommend keeping at least 75-90% of your portfolio in index funds (which I’ll describe below), and only allowing yourself to pick stocks for the other 10-25%.  That way, if you lose your shirt, you’ll still have plenty of assets to fall back on.  Alternatively, you could designate your retirement funds as index-only, and stick to taxable accounts for any stock picks.  (I do this, since I don’t want to screw up my age 60 retirement accounts (401k & Roth IRA), but am willing to take a little more risk on my ‘early retirement’ accounts.)

Also, diversification (owning different stocks in different industries) helps you lower your portfolio’s risk.  The right index funds give you that diversification so that you don’t have to worry about it as much when you’re picking individual stocks.

1) Educate yourself

Peruse investing education websites like the Motley Fool (which has been going downhill for the last few years; but you can still find some good stuff on investing like this, or this.)  MoneyChimp is a great site too, with many investing (and general personal finance) calculators available.

Read superinvestor Warren Buffett’s ‘Letters to Berkshire Hathaway shareholders’ for free online (or consolidated in a much easier format in this book.)  The best book I’ve read to get a feel for the correct general investing philosophy is Roger Lowenstein’s Buffett biography.  I recommend this as a must-read for any would-be investor to learn the correct investing temperment, which is just as important (if not more so) as learning how to value stocks.

Finally, read Benjamin Graham’s classic ‘The Intelligent Investor’.  Graham was Buffett’s teacher and, together with David Dodd, pioneered value investing with ‘Security Analysis’.

(One word of caution: if you ever come across someone touting ‘technical analysis’, otherwise known as ‘charting’, run the other way as fast as you can!  Technical Analysis is a stock picking method akin to voodoo (and just as scientific.)  It involves looking at the past patterns in past price data (random movements in the market) for a given stock.  Supposedly, patterns like ‘head and shoulders‘ (I’m not making this up) are ‘buy’ indicators, whereas the ‘rounding top‘ pattern is something to fear.  If you think trying to divine future stock movements from random patterns in past price data sounds crazy, you’re right; don’t give this garbage any space in your brain.)

2) Do your homework

Once you find a company you’re interested in, start looking at their financial data and business model.  Order by mail or download their annual reports (10-K’s) and quarterly reports (10-Q’s) from the Investor Relations section of their website.  Do whatever valuation techniques you like, but at a minimum compute some ratios (PE, PEG, Current, Quick, etc) and do a Discounted Cash Flow (DCF) analysis on a company’s Free Cash Flow (FCF.)   Valuation matters!

3) Plan to buy and hold a company… forever!

Warren Buffett is often quoted as saying his favorite holding period is forever.  What he means is that if you do a thorough job in steps 1 and 2 above, you should have found a company worth holding for a very long time.  Ideally, that great business would continue to be a profitable investment for years to come, so why wouldn’t you keep the stock?  There are some legitimate reasons to sell, maybe the business has changed, or maybe you overlooked some glaring issue at the time you purchased.  Maybe the all-star CEO has left and you’re not comfortable with her replacement.  Or, maybe you finally need the money.

Other than these reasons, plan on holding for a very long time.   Buy and hold investing forces you to do your research up front.  It also keeps you from trading too much, which incurs large costs and lowers returns dramatically.  Not only that, but the IRS tax code favors investors who hold their investment gains as long as possible (this last consideration doesn’t matter for retirement accounts that are tax-advantaged, like 401ks or IRAs.)

4) Track your portfolio’s performance against an appropriate benchmark index

This is absolutely critical to knowing whether you’re profitable as an investor or not (which is the whole point of putting in all the effort of picking your own stocks: beating the market!)  I recommend keeping your brokerage account that you use for individual stocks separate from the rest of your investments (like index funds, bonds or money market funds.)

After you calculate your total return, calculate what your total return would’ve been if you’d made the same investments (amount and date of investment) in an index fund like the S&P 500.  Ideally you would like as long a time period as possible, as random fluctuations in your portfolio can make you lucky (or unlucky) in the short term.  Check your portfolio’s return against a benchmark at least every 6 months to a year.  If you can outperform the market for 3 years or more by a 1-2% each year, you’re doing well.

Conclusion

It’s very difficult to gain the knowledge, emotional attitude and discipline to be a successful stock picker.  By using the resources about you’ll have a better chance than most, which still may not be enough.  Stock picking can be fun, but make sure you’re giving yourself constant reality checks by measuring your entire portfolio’s performance against a major stock market index fund like the S&P 500.  Use a buy and hold strategy with a long-term (5+ years) holding period.  Thoroughly investigate the pros and cons of every investment before you buy.  Good luck!

Final word of caution and advice

Be brutally honest with yourself: if this all sounds like too much work, or if you know that your initial excitement to do the work will lose steam in a few months, just buy broad low-fee index funds.  Even ‘buying the market’ will result in huge compound returns over time, and beats the vast majority of professional money managers, not to mention all your friends trying vainly to beat the market but failing.  Not only that, but index funds offer practically ZERO work and maintenance, allowing you to ‘set it and forget it’ and get on with the rest of your life.

http://www.fool.com/investing/small-cap/2005/07/11/computing-your-investing-returns.aspx

Do you know how much you need to save for retirement, college, or a home?

This handy savings calculator from Lifetuner.org helps you answer that question.  Just plug in a yearly savings amount (like $200/month = $2400/year), the ages you start and stop investing, your desired retirement age, and an interest rate.  For this last assumption, I would use 6.8% (or 7% if decimals are too much to handle) to match the historical, real (inflation-adjusted) stock market return.  That way you won’t fool yourself into thinking you’ll have more purchasing power (which is what matters) than you really will have.

You can run up to three side-by-side simulations.  Compare starting ages, amounts you save, or the difference due to small interest rate changes.  This is a great calculator for estimating the return from regular investing, or the difference in gain from, say, a 0.5-1% increase in return due to switching to low-fee index funds, which beat the returns from (higher-fee) actively-managed mutual funds 70 – 80% of the time.

You can use this to calculate ANY regular investment, not just one for retirement.  For example, if you want to have a house downpayment in 3 years, assume a bond fund return of 3-5% (rates are low today) and then see how much you’d need to invest yearly to achieve your goal.  The longer you can wait, the more you’ll have.

Or, to calculate savings for your kid’s college (new parents, pay attention!), enter your kid’s current age as the ‘start saving’ age and 18 as the ‘stop saving’ & “retirement” ages.  (“Retirement” in this calculator just means the date when you want to know how much you’re investment will be worth.)  Use the historical, real, stock market return of 6.8% if you have a long time (>5 years) to invest, since that’s where your college savings should be.

Stay away from leveraged mutual funds and leveraged ETFs!

I just read a good article at ‘Seeking Alpha’ on the dangers of leveraged mutual funds and ETFs (Exchange-Traded Funds.)  A leveraged fund is one that uses fancy sercurities like derivatives and options to double or triple the daily returns of an index (like the S&P500, for example.)  However, this does NOT actually double (or triple) the total return for several reasons.

1) Constant rebalancing: Leveraged funds must buy more stocks when markets go up in order to maintain a certain ratio of leverage to investment (1:1 for a ‘double’ fund.)  Similarly, in down markets these funds must sell off their investments.

This creates a large amount of trading (read: transaction fees) and short-term capital gains (read: taxes.)  If you don’t know already, rapid active trading is a dumb investment strategy because the fees and taxes eat away your potential gains.  (You’re better off buying and holding broad, low-fee index funds, or an ETF of that index fund.)

2) Interest payments: All that debt that leverage funds use doesn’t come free.  These funds pay interest and fees to use fancy securities, which comes straight out of your pocket.  As you can see in the article I mentioned above, this results in woeful underperformance in bear markets (= market going down), with only slight overperformance (of the underlying index) in bull markets (= market going up.)

I would bet that over the long-term, these funds & ETFs will underperform the market, or at least not come close to making up for their huge risks and volatility with increased return.  Instead of looking for a get-rich-quick scheme by leveraging to the hilt, look at much better places to put your money.

Bottom Line: Stay away from leveraged mutuals funds and ETFs, they could be hazordous to your wealth!

(As an aside, I should note that the idea of leveraging (slightly) an index for the long term is not altogether a bad thing, and may be helpful if done in the right way.  However, the current set of leveraged ETFs and mutual funds that take on monster leverage and result in high fees and constant trading are BAD.  That’s not to say that an individual investor couldn’t use index funds in a margin account or other options (that the Seeking Alpha author suggests) to use leverage intelligently.  However, that’s a topic for another day, and one that I really don’t think anyone reading this needs to be worried about.  As of today, I use NO leverage in any of my financial securities (= stocks & bonds) investments.)