As of the end of 2023, there were over 5,700 stocks listed on the two major US exchanges, the Nasdaq and the NYSE. That creates a problem for those who wish to trade or take an active role in managing their investments: With that many choices, how do you decide what to buy?
Well, the obvious answer is that you do some research and analysis, but that still leaves the question of what to research and analyze. Over my forty years or so in and around dealing rooms and financial markets, I have heard many theories as to how to approach that problem and have settled on a process that has worked for me. Hopefully it will make sense to you and work for you, too, but the most important thing is to have a process and to do things in a logical order.
There are two types of analysis that stock traders and investors typically use: technical and fundamental. Technical analysis is primarily concerned with looking at charts, the visual representation of price history. Fundamental analysis is, as its name implies, more about assessing the fundamental influences on the company whose stock you are analyzing: Do the economic environment and consumer trends suit their business? Are they profitable, and if so, can they be expected to grow their profits? Is the company well-run? Does it have a solid balance sheet with no liquidity issues? How is the stock priced in comparison to the market as a whole and to its industry or sector competitors?
The fact that fundamental analysis demands answers to so many questions is probably why most people prefer to look at charts. At first, fundamental analysis seems more difficult to understand and seems to require some specialist knowledge, particularly if you believe that one chart pattern or signal is a reliable sign that something is going up or down and is easier to decipher.
However, starting with technical analysis is usually a mistake. No matter what the chart says, if the economy as a whole is going down the tubes, or if an industry is being disrupted by new technology or a shift in customer trends, a stock that is impacted by that likely will not go higher. Technical analysis and chart reading have their place in stock analysis, but they should not be your starting point.
The more logical way to structure your research is what is known as a “top down” approach. That means starting with an assessment of the overall economic situation, then looking at trends and technological advances. That should lead you to identify what kind of businesses will benefit from current conditions, enabling you narrow it down further to those within that group that have the best past performance and future prospects.
Then you should look at each from a value perspective. Does one have a lower P/E than its peers, and if so, why? It may be for a good reason, because the company has some competitive disadvantage or whatever, but sometimes it has been overlooked as investors focus on other, trendier names in the industry.
That all takes work on your part, but in trading and investing, as in life, it is hard to achieve much without putting in the work. After a while of doing this, you will find that you’ll be able to quickly narrow things down to just a few stocks that are positioned to benefit from the prevailing conditions and trends. That may be because they have great potential or great value or, in an ideal world, both, but usually, if you keep an open mind, you will arrive at one stock before too long.
Only then do you think about charts. Their main purpose is to help you decide when to buy and, further down the line, when to sell. There is no magic system for doing this, but the key is usually to keep it simple. For example, if a stock is near the bottom of an established range, it is more likely to go up in the short term, so now is probably a good time to buy it. If, on the other hand, it is near the top, wait and see. It may retrace back into its range, creating a better buying opportunity in the future.
Understand, though, that even if your research points to a stock that “should” go up, there is no guarantee that it will. Conditions could change, or you may have missed something important that others are seeing. If that is the case, then don’t just hang on to the stock. Admit that you got it wrong, cut the position, and try again.
If you do all this, there is, of course, no guarantee that you will be a successful investor or trader, but you will have given yourself the best chance at that, which is the most you can do.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.