4 Basic Steps to Buying a Stock
Once you decide that you want to buy a stock, you need to have a strategy for buying it. Smart investors know that this is more than simply calling up your broker and asking for a certain number of shares of the stock. You need to be more tactical than that if you want to be a successful investor. With that being the case, here are a few tips that will help you accumulate a stock in the most effective way possible.
1. Use limit orders
A limit order is an order you place with your broker for which you decide the price at which you buy a stock. For instance, if stock XYZ trades at $102/share, you might put in an order to buy 100 shares at $100/share. On the other hand, a market order is simply an order to buy the stock at whatever the market price is. So in our example, you might put in a market order to buy 100 shares of XYZ, but while the last trade was at $102/share, you have no idea what price you will pay. So it is possible that just before your order goes through some market glitch sends the shares soaring to $105/share. For this reason, you always want to use a limit order when buying a stock — even if you put in a limit order of $102 to buy a stock that last traded at $102 use a limit order to ensure that you decide the price you pay for a stock.
2. Never buy all at once
Finding a new investment idea is exciting in much the same way that winning at the casino is. But it can also cloud your judgment. You might decide that you want to make this your new biggest holding, or that you want to sell some other investment(s) in order to buy this new one. But no matter how strong your conviction is, the fact remains that a stock is a stock, and it is subjected to market forces. All stocks go up and they go down.
Furthermore, you are unlikely to pick the bottom, and if you can do this then you should become a professional trader. The best strategy to employ is to buy a little bit at a time. For instance, if your new investment idea trades at $100/share and you want to invest $10,000, then start out by buying 10 shares with a limit order of $100. Then maybe put in another limit order to buy 20 shares at $95/share or even at $90/share. As time passes, you will be able to evaluate your investment more objectively, especially if you see its share price fall. You may decide to stop buying after you’ve accumulated $2,500 or $3,000 worth, or you may choose to continue. The point is that you want to take advantage of market volatility, and you want to slowly accumulate positions.
3. Dollar cost average
Chances are you are investing money that you earn from a weekly or monthly salary. You should set aside a little bit of money from each paycheck to add to your positions. You will not pick the bottom, but you will accumulate a lot of shares over time, and if you are right about the quality of an investment it won’t matter so much if you bought at $100/share or at $90/share. Dollar cost averaging takes the emotion out of investing. It also enables you to buy more stock when the price is down, and you end up buying less when the price is high. So long as you are committed to the position longer term, dollar cost averaging is a good strategy.
4. Have a list of stocks to buy, and take advantage of weakness
This deviates from the “how to buy a stock” theme but it is solid advice for those of you trying to construct a portfolio. What I like to do is have a list of a few stocks that I want to buy. When I get money that I want to invest, I will look at my list and search it for weakness. If you have a big enough list (more than 3 – 5 stocks) chances are that one or two of the stocks you want to own will be trading down. These are the stocks you want to favor when you add to your positions. That isn’t to say only buy the weak stocks, but if you favor the weak holdings, provided they are still quality investment choices, this is a strategy that should work out over time.
Before you buy, you must pick the right stock. Last week, we wrote on how to pick a winning individual stock from a sector you think has potential. Here is a recap of the ways to find the “best of breed” stock in a sector:
1. Bigger is better
Bigger companies often have more access to financial resources. They can borrow money more easily. They can also better handle competition. If you aren’t convinced that bigger is better, then just consider that Starbucks has expanded in the past by opening up new locations next to existing coffee shops, beating them on price — even if it meant operating at a loss—and running them out of business. Big companies can afford to do this because they can make up for any losses through other parts of their businesses. This isn’t a hard and fast rule, but if you are choosing between two stocks in the same sector with similar valuation metrics then unless you have a good reason to do otherwise, pick the bigger one.
2. Brand power
This is closely related to “bigger is better,” but we all know the power of brands. National Beverage may end up being a better investment than Coca Cola, but using our basic intuition we can guess that your typical consumer will be more likely to buy a Coke than a Shasta. We know this because we know the Coke brand extremely well. Nike, McDonalds, Disney and JP Morgan all have universally recognizable brands in competitive industries, and they are better positioned to succeed than their competitors because of this.
3. Look at the right financial metrics
We’re often taught to look at P/E ratios and that a lower P/E ratio makes for a better investment. But this isn’t necessarily the case. In fact if two companies in the same sector have two different P/E ratios the one with the lower P/E ratio might be growing more slowly, or maybe it has weaker brand power. Thus one way to look at financial metrics more objectively is to look at those that reflect the company and not the market’s valuation of the company. So, for instance, look at return on assets — how quickly is a company growing its assets? Look at return on equity — how quickly is it growing the overall value of the company? Look at its return on investment ratio — how well does the company invest its money? Superior metrics in these categories reflect well on management, and you want to own the leaders in these categories.