Investing your hard earned money in the market must always be a well planned process. Since real money is on the line, any mistake or impulsive decision may result to financial loss. As such, careful planning is needed to mitigate risk and build consistent profit over time.
Process Oriented Stock Selection Method
The process of buying a stock can be simplified to 4 steps:
First, you build a Trade Strategy that aligns to your investment horizon, risk tolerance and lifestyle.
Second, scan and select stocks that strictly align to your strategy. This should allow you to build a watchlist/shortlist of curated stocks that pass your trade criteria.
Third, you monitor the stocks under your watchlist for any market signals through the use of a Trade Plan.
Buy once the entry signal is triggered.
Notice that in this process, stock selection is the second step and NOT the first. Why? Because every stock you buy must ALWAYS comply to your Trade Strategy. Without the use of a strategy, you will be buying with no clear direction and will likely encounter heavy losses.
As such, the start of any stock selection process is the creation of a well crafted Trade Strategy.
As a guide for building a trade strategy, you may visit this post.
Determine Your Strategy First
A Trade Strategy, is the general roadmap of your trading/investment journey. It is the utmost reference of your trade decisions.
As a basic template, here are the common elements that any trade strategy must answer:
Investment Horizon
Risk Tolerance
Market Sentiment
Market Cycle
Allocation
When your trade strategy is clear, you can now start the process of stock selection.
Since your strategy contains all the criteria that align to your investment preference, it is also the basis of the stock selection process.
The Stock Selection Process
As a basic guide, we will carry over the elements of the trade strategy and use them as the primary selection criteria for choosing the appropriate stocks:
1. Picking a stock based on Investment Horizon
Your Investment Horizon is the amount of time that you are willing to hold a stock position.
Short Term: 1 day – 1 month
Short term traders rely on price action through extensive use of technical analysis. They analyze chart patterns, volume and underlying market sentiment to generate quick profits.
Medium Term: 6 months – 3 years
Medium term traders use a balanced mix of fundamental and technical analysis for a lower risk portfolio with modest gains. Fundamentally sound stocks that pullback during weak economic climates are preferred picks. As such, a longer waiting time is needed.
Long Term: 8 – 10 years
Long term investors do not bother the daily volatility of the market. They refer to monthly charts and heavily based their investment decisions on fundamental growth.
Long term investors go for cost averaging and value investing strategies on strong earning companies that are under sectors with good long term growth potential. Since fundamental growth takes time, the investment period lasts 8-10 years if not more.
IMPORTANT
When deciding the appropriate Investment Horizon for you, note of the following principles:
Fundamental Value is the primary basis of Long Term investing.
Price Action through technical analysis is the primary basis of Short Term trading.
2. Picking a stock based on Risk Tolerance
Risk Tolerance refers to the amount of risk that you are willing to accept for every trade you make. As a basic introduction to risk, we can use a stock's fundamental quality as an initial basis. Generally, the fundamental quality of a stock can be determined by how good or bad their financial books are (assets and liabilities, earnings, market capitalization, volatility, volume).
Companies with good fundamental quality are usually those under High-Medium Capitalization. These are high earning companies with stable liabilities and robust assets. For the basis of fundamentals, these can be regarded as Low Risk stock picks.
Companies with bad fundamental quality may fall within the Low Capitalization range. These are usually start ups or small companies with volatile earnings or are very speculative in nature. Due to their speculative and unpredictable earnings, these stocks are very illiquid and are prone to price manipulation. These can be regarded as High Risk stock picks.
IMPORTANT
Short term traders that use Technical Analysis to read volume and price action can actively trade High Risk stocks. These however require extensive experience and skill to execute properly.
Medium to Long term traders rely on Fundamental Value to be able to accumulate fundamentally sound low risk stocks over time.
3. Picking a stock based on the market climate
Another important criterion for stock selection is the awareness of the current Market Climate condition.
The current market climate tells you whether you can be aggressive or defensive in terms of your strategy.
During Bullish market conditions, the investing public is aggressively buying stocks causing the market to rally. However, during Bearish market conditions, the investing public is usually selling continuously which causes deep market sell offs.
When picking a stock, always monitor the current market climate to determine if it is a suitable time to buy or not. When the market is Bullish, prices continuously move up. During this time, a Buy High, Sell Higher approach maybe ideal. But during Bearish market conditions, simply remaining in cash maybe a wise option.
In a Nutshell
Picking the right stock is a highly methodical process. Since your hard earned money is on the line, you want to exhaust every means possible to lower the risk and maximize the gain. This is why every selection process must be aligned to your personal Trade Strategy. In this way, every stock you buy will match your exact preference and you will more likely end up with consistent and stable profit.
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