Imagine a pilot taking off a plane without going through a checklist. Did the pilot make sure that everything was in order on the checklist? No? Boom! There’s your crash. You don’t want a similar, unwanted crash in your investment portfolio. Investing in stocks and avoiding common investment mistakes, much like piloting a plane, needs time, attention, and a comprehensive checklist. An investment checklist can be a lifesaver when it comes to making money prudently.
Contrary to popular belief, the lifeline of a checklist doesn't just end at the investment of your first stock. As the famous Warren Buffett quotes:
"Buying a stock is about more than just the price."
Take a look at this ultimate checklist, which tells you what your game plan should be from the moment you think of investing to the point where you start making money from stocks.
Stage 1 - Before You Start: A Pre-Investing Checklist
At this point, you may not know the parameters you need to keep in mind before entering the stock market. It is a given that doing your homework and research before plunking down your money on a company’s stock is extremely important. So, to avoid unnecessary confusion when you kick-start your journey in the stock market, keep this pre-investment checklist handy.
- Secure Emergency Funds – Being financially precarious is scary. Investing in stocks is a great opportunity and, if done properly, yields tremendous results. But, having a good stash of cash tucked away in a safety deposit will always help you stay one step ahead.
- Clear off your high interest debts – Although stock market investment might seem tempting because your money is doing the work for you, ensure that you’re not digging yourself into a bottomless pit of debt and financial crisis. Pay off any high interest debts or credit cards that are outstanding. Before taxes,
you have to be earning more than what you’ll end up owing, stay on the smart and safe side by being debt-free.
- Research, Review, and Read Some More – Despite what you hear from some of the occasional “lucky pundits”, if there’s no work, there’s no gain. Getting lucky on the stock market might do you good in the short run, but if you’re in it for the long run, you need to bank on tons of research. Read about the company’s history, growth, products and services, board of management, the CEO, affiliates and review its past and current performance.
- Pick the right broker – Needless to say, a low-cost but efficient stock broker is a wise choice. There are established resources online that will give you access to reputed online brokers.
- Be familiar with the tax consequences – Familiarize yourself with wash sales, capital gains rules, and anything other tax rules that could help you when you’re filing your tax returns. You can sometimes write off stock losses provided that you follow certain procedures.
- Perform a Financial Statement Analysis – Once you are through the preliminary research do a financial analysis of the company. You’ll need to carefully assess the following financials:
To be more thorough, you could also go through the company’s 10-K and 8-K reports. These reports are easily available on the U.S. Securities and Exchange Commission website. A thorough financial analysis makes stock screening relatively easy. And the best part is, if you don’t have time to screen a company's financials, you can always hire a professional to do it.
Stage 2 - Stock Picking: Checklist To Select The Right Stocks
- Know Your Stock - Spend a good chunk of your morning tea time on the business and finance section of your newspaper. Keep a close eye on the stocks of the companies that interest you. During stock selection, it is important to know what stocks are making news and for what reasons and learn to recognize warning signs of bad stocks. Stock prices are affected by a number of things that go on in a company, including company earnings, quarterly or annual results, acquisitions, mergers, alliances, introduction of new services and products, and changes in the top management. You need to know what the company does and whether it’s a profitable business. Not only will this help you stay ahead of other investors, but it will also help you make smart investment decisions.
- Avoid One Hit Wonders - The stock market has companies which debut based on a bullish market trend or initial success. Investors should avoid one time wonders to avoid losing money. Remember what happened to Zynga (NASDAQ:ZNGA)? Take a look at how Zynga stock price has fallen over the years. For companies like Zynga and King Digital (NYSE:KING) which have capitalized on their first successful game, revenue is not sustainable.
Source: Zynga stock chart by Amigobulls
There’s an important lesson to learn from here. Always ask yourself this question - Do the company’s services and products have enough market potential to maintain a sizable and consistent increase in sales for several years? If all research suggests it doesn't, then it’s time to find a company with the potential to do so.
- Optimistic Growth Rates – Steady growth rates over a long period means that the stock price will appreciate on the long run. Check the growth grade and if it’s an ‘A’ or ‘B’, it’s a safer bet than anything with a lower grade.
- Ownership – If at least 30% of outstanding shares are under institutional ownership it’s usually a good sign because it means that institutional buyers believe that they can profit by owning that particular stock.
Stage 3 - Trading in the Stock Market: Your Final Checklist
- Keep An Eye On The One-Year Price Chart With A 50-day Moving Average - This chart will help you watch your stock’s performance closely and also assist you with stock selling. People usually tend to buy stocks that are in a downtrend because of the low price. But, it’s dangerous to do that. However, if the stock is moving above its 50-day average then it might be ok to buy it.
- Watch Out for Price/Sales Ratio - It is always recommended to maintain a valuation check on your stocks. Make your buy and sell decision based on the P/S ratios of the stock. It particularly makes sense when investing in tech stocks, as most tech stocks are not profitable at the time of their IPO. Also, sales of a company is always a good metric to base the stock price upon.
Source: Amazon price to sales ratio by Amigobulls
The example above shows the price-to-sales comparison of e-tailer Amazon (NASDAQ:AMZN) versus its peers Walmart (NYSE:WMT) and eBay (NASDAQ:EBAY). A low price to sales ratio with increase an in stock price implies an increase in sales. In the chart below Walmart price to sales ratio is the lowest, indicating it might be a better investment compared with Amazon or eBay. Then again this metric alone is not sufficient and an investor must check other parameters as well.
- Take A Look At The Price-to-Earnings ratio (P/E) – When you’ve been reaping benefits from a particular stock for years, the P/E ratio can be a useful indicator of whether a stock is either a bargain or too expensive. A low P/E ratio means that the stock is a bargain, but a comparatively high P/E ratio might signal the fall of a high-priced stock. But you have to keep in mind that growth stocks usually have a high P/E ratio. A good example of this is Amazon. Amazon's high PE ratio has always been a topic of discussion for investors. Make sure that you compare the P/E of your stock to the industry’s average P/E, as well as the market’s average P/E.
- Regularly Check The Company’s Financial Health Grade - Stock investment might be a gamble for many, but a smart investor always sticks to the company with strong financials. Focus on trading stocks that have a Financial Health Grade between A and C.
- Chart Out Your Next Plan - One thing about the stock market is that you can’t freeze and expect your investment to mature. You need to be ahead of time, plan your pre-investing techniques and identify new investment ventures. So, constantly improvise.
Investing in the stock market could turn out to be a roller coaster ride. If one follows a method to investing, stocks to a plan, and does enough research, one can make money, even during a stock market crash!
Do tell us the investing ideas that have worked for you in the comments section below.