When you invest in stocks, you can select among publicly traded companies listed on stock exchanges, public companies whose stocks trade over-the-counter (OTC), and those that are nontraded. You may also buy stocks issued by companies based in other countries, especially those listed directly on US markets or sold as American depositary receipts (ADRs).
Given this variety, you need a strategy for choosing among them — or perhaps a number of strategies geared to specific market conditions. For example, you may take a different approach to select investments in bear markets than you do in bull markets, or in periods of higher as opposed to lower interest rates.
Whatever your approach, selecting appropriate is usually a two-step process: first, finding stocks that are strong contenders on their own merits, and second, identifying those that will fit well into your investment portfolio.
Building a portfolio
If you buy stocks solely on the basis of their individual merits, rather than as part of a broader portfolio strategy, you risk committing too much of your principal to stocks that tend to behave the same way. For example, if your entire portfolio is made up of blue-chip stocks, you’ll probably benefit in the years when large, well-established companies are providing strong returns. But you may suffer in years when these stocks provide negative returns, which all types of investments do from time to time.
One of the keys to maintaining a balanced portfolio is diversification. You diversify by investing in a variety of stocks that react differently to changing market conditions. That way, you can benefit from those that are flourishing at any point in the economic cycle and ride out the disappointing returns of those that are foundering. Remember, though, that diversification doesn’t guarantee a profit or protect against losses in a falling market.
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One way to begin diversifying your portfolio is to recognize the different ways that stocks can be grouped.
Market capitalization, often shortened to market cap, is a measure of a company’s size. The performance of small-, mid-and large-cap stocks varies in a recurrent but unpredictably timed pattern, with each type providing better returns at some times and weaker returns at others.
At times when domestic stocks may falter in a general downturn in the US economy, international stocks may be providing a strong return or the reverse.
Cyclical stocks in economy-sensitive industries, such as automobiles and travel, tend to lose ground when the economy is weak and gain when it’s strong. In contrast, the defensive stocks issued by companies supplying staples, such as food, utilities, and medicines, are typically independent of turns in the general economy.
Growth stocks vs value stocks
Another portfolio consideration is the difference between growth and value stocks. You may look for growth in young companies in burgeoning industries poised to increase their earnings at a faster-than-average rate. However, established firms can also provide substantial if sometimes slower growth. The general assumption about growth companies is that their future earnings will be significantly higher than they are now. As a result, these stocks often trade at P/E values higher than the market average.
In contrast, value stocks may be worth more than investors are currently willing to pay for them. Since these stocks often have P/Es lower than the norm, you might liken value investing to bargain shopping. The classic value stock has been issued by a reputable company with quality assets, operating in an established industry in which investor interest has lagged – sometimes deservedly so. The expectation in buying a value stock is that the market will sooner or later realize the company’s strengths and demand for the stock will increase again, pushing the stock price higher.
Owning company stock
One of the most perplexing decisions is whether to buy stock in the company you work for or hold onto the stock you’re granted by the firm or that you have the opportunity to buy at a favorable price. Arguments in favor emphasize that you know a great deal about the firm — including its strength and its weaknesses. And recognizing your hard work will put you in a position to share in the company’s success may make going to the office early or working overtime easier. Further, if you work for a profitable company whose shares split and whose stock price rises over time, your investment may be extremely profitable.
On the other hand, concentrating your portfolio in any one company — especially your own — makes you more vulnerable to losses than if you diversified across market capitalization, sector, and style. When a company in which you invest is also the one providing your paycheck, that risk is magnified. A solution may be to cap your ownership in your company’s stock at a certain percent o your total portfolio.
Who is contrarian?
A contrarian goes against the flow — buying what other investors are selling and selling what other investors are buying. If others are unloading technology stocks, contrarians look for tech stocks to buy. If large-cap stocks are in demand, contrarians sell them. Bucking the trend has been a successful strategy for some investors, but it does have risks.
Identifying time to sell
Buying a specific stock at a particular time can have a major impact on your portfolio. But don’t underestimate the importance of a timely sale. In fact, it is just as important to have a strategy for selling as it is to have one for buying. Choosing when and what to sell often depends on changes in the issuing company’s financial stability or management, changes in the overall economy, or a major change in the stock’s price that doesn’t necessarily reflect what’s happening in the markets as a whole.
You may want to sell to realize capital gains, perhaps as a precaution if the stock seems to be losing value. But it’s a good idea to consult your tax adviser before you make a final decision to clarify the potential tax consequences of the sale.
How To Pick Stocks For Your Portfolio? by Inna Rosputnia
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