Andrew is a self-educated business owner and entrepreneur with plenty of free advice (which is worth exactly what you pay for it!).
Stock investing can seem overwhelming, especially if you're just getting started, poking your head out above the index fund clouds to see the wild blue yonder of active stock picking. It seems like so much fun, but it can also seem impossibly daunting—you may feel as if you're one of the people destined not to have any fun.
Even if you've been managing your own money for some time, a little bit of procedural organization and clarity over the process can be incredibly helpful. What follows is an overview of the method I use in order to identify a group of stocks that I might be interested in buying, how I know when to buy which stocks (and why), and how I know when to sell a stock.
The process of buying one stock at a time can't be separated from the portfolio management aspect, since the latter informs how you think about the former and provides rules on how and when to buy, so we'll cover how that integrates into your decision-making process as well.
Finally, we'll need to discuss a few of the psychological elements of stock investing. One huge benefit of having a set of guidelines that is more or less set in stone is that you don't get distracted by the more emotional aspects of the market.
A brief word about the order of operations: It's important to go through each of the steps outlined here, but the process becomes cyclical and self-reinforcing over time, so getting started is going to prove considerably more difficult than managing an existing portfolio should be. Hang in there!
How to Start Building Your Portfolio
In order to build a portfolio of any sort, you're going to run into your first chicken-or-egg conundrum: Which comes first, your portfolio design or the stocks you're buying?
Fortunately, the answer is that it can work either way. You can start by picking out a few stocks to monitor based on the best values you can find (or based on a basket of great companies you want to follow) and then shape the rest of your portfolio around the existing stocks. Alternatively, you can think of portfolio construction first, then build out the stock picks as they become reasonably priced, building within a constrained framework and guiding set of principles (sectors, geography, or size of the company are great factors along which to diversify).
If you need to get started, here's a very simple version of the process I'm describing that can get you off the ground fairly quickly.
How to Identify Stocks You're Interested In
You may constantly wrestle with whether your portfolio is top-down (you have preset rules) or bottom-up (you identify the best opportunities one at a time). While trying to buy or sell stocks purely based on market timing or macro forces isn't something I'm into, I have found it to be extremely useful to work within some constraints.
Ideas for stocks to buy can come from a wide variety of places, and you may find dozens (or maybe even hundreds) of companies interesting enough to want to follow. In this case, you may want to use a preset filter and only follow stocks that meet certain criteria. It's generally best to use a checklist (like this one) in order to help you whittle down your selections.
Run each business you identify through a set of filters, so you only end up following a manageable handful of companies; I can't tell you whether you should follow 20 or 200 companies, but that's going to be informed by your available bandwidth, time, and appetite for research and due diligence.
If you have less free time for this sort of thing, your list should be on the smaller side, but if you're able to allocate several hours a week to learning and following companies, a much bigger basket can work well. In a perfect world, the stocks you're identifying all share these characteristics.
Characteristics of Good Stocks to Follow
- They're cheap (or at least fairly valued) and probably not too far off from where you'd consider buying them.
- There's an upcoming catalyst that could help them realize their intrinsic value—something that could cause the stock price to spike sooner rather than later.
- There's a margin of safety in case you're wrong about there being a catalyst, or if you've estimated the intrinsic value too generously.
- There's a moat around the business, allowing plenty of time for the business to realize its fair value or continue to grow.
- The management team is solid, and there's not a ton of debt.
How to Decide When to Buy
Once you've got a few stocks in your portfolio, the rules you're using are going to dictate what to buy next and when. This is a great place to introduce opportunity cost and to consider how that comes into play when factoring in all the relevant factors.
Economics is the study of how trade-offs work, or how money (or any scarce resource) might be used differently. If your portfolio has a steady stream of cash coming in, you can buy a lot more freely, and you might consider letting more companies into your stock universe. On the other hand, if you have a fixed amount of money you can contribute, you might need to sell a stock you already own in order to buy a new one (or more of another stock).
So, you identify a fantastic deal, you run it through your checklist. If it fits into your portfolio well . . . so far, so good. But there's one problem: You don't have enough cash to buy the stock you want. This means identifying the stock you own that you least want to own, and then comparing keeping that stock to buying the new one. If the stock you're considering selling is deeply undervalued and you think it's going to realize full value sometime soon, you'd probably take a pass on the new opportunity, but if the least-wanted stock you own is clearly a worse value than the alternative you're considering, it's probably a buy right now.
I personally have several different portfolios, each with a different ruleset, so that I can run several little experiments at a time. You may want to consider trying a few different approaches in order to figure out which style works best for you.
How to Decide When to Sell
Knowing when to sell can be tougher than knowing when to buy. One incredibly easy way to know for sure is to use the opportunity cost method described above: If you have a better bargain, it may be time to sell the stock you want the least in order to be able to buy the new hotness.
On the other hand, if you've got some cash on the sidelines (perhaps you have a policy to keep a certain amount of dry powder in your portfolio), selling may never be triggered by a need to buy a new stock. In this latter type of situation, it's still prudent to sell stocks from time to time, keeping in mind that there may be some tax implications to selling, depending on your personal financial situation.
Don't let the tail wag the dog here, though—your goal shouldn't be to pay the least amount of taxes possible; it should be to make the most after-tax money possible! Don't mix these two things up.
How to Decide Between Selling and Holding
Still, knowing when to sell can be very challenging. I have two ideas that may help you out with this most challenging aspect of portfolio management. First, remember that the best diet is the one you can stick with. Don't try to be ideal or perfect in your buying and selling decisions. Instead, try to be realistic about what you can do.
For me, this means selling when a stock approaches fair value. It turns out that I'm good at identifying stocks selling at a deep discount, so that's what I do, and as they approach what I consider to be their intrinsic value, I sell before the stock gets there.
Cleaning out my portfolio frequently like this acts as a very practical hedge against any kind of major crash since I've already taken profits, and whatever I'm holding at a particular time should be undervalued and more likely to recover.
Instead of allowing stocks to run up above fair value before selling, I prefer to "trim the weeds" frequently enough to ensure that I'm not holding onto too many of the type of stocks that are most likely to crash in the event of a selloff.
Even though this works really well for me, you might have the opposite issue, where you're much better at letting your winners run. I'm awful at letting my winners run, so I usually sell sooner rather than later (and since I'm better at identifying undervalued stocks in the first place, this makes logical sense).
This brings me to my second idea: You don't have to hold all of one stock in one portfolio, and a sale doesn't have to be an all-or-nothing event. In other words, you could sell half of a stock in order to raise funds for a new stock purchase (or simply to take profits) if you feel a stock might be running hot. You could have some of both worlds this way, allowing a winner the room to run while also taking some profits off the table.
The Never-Ending Stock Story
Remember that building a portfolio is a lot more challenging than maintaining one. At first, you have to consider all these portfolio construction and governance rules, avoiding the most common mistakes along the way. You also have to identify and then filter through stock ideas, which can involve a great deal of research.
However, this process gets easier as your portfolio grows for a few reasons. First, your list of potential stocks to buy will still have to be maintained, but instead of checking your Google Finance or Seeking Alpha list, you can start with your best set of prospects: the stocks that are already in your portfolio. If something you already own has just gone on sale, that may well be your next purchase, provided you're following your portfolio's rules (e.g., you might have an arbitrary rule not to have more than X% of your portfolio in one stock).
Another huge benefit to having already built a portfolio is that the second place you can check for stock ideas is the group of stocks you've previously sold. When you look at the stocks you currently own or have owned at some point in the past, you're going to know these businesses really well already without needing to do those hours of due diligence. It's much easier, then, to decide whether you should sell a stock you own right now in order to buy a stock you've owned in the past or own currently: Just ask yourself which bargain is better.
This article is accurate and true to the best of the author’s knowledge. Content is for informational or entertainment purposes only and does not substitute for personal counsel or professional advice in business, financial, legal, or technical matters.
© 2021 Andrew Smith