10 Questions Before Buying a Stock
- Why are you buying this stock? You need to be able to define why you like a company's stock before buying it. Buying because you heard a great stock tip is a recipe for disaster. The investors who can time their entry into the next "hot stock" are rare to find after the tip has trickled through Wall Street and down to the retail investor who hasn't done research on the company and its stock.
- Why is the price right now the best entry point? Buying a stock simply because a company seems like they have a great product or a great growth plan isn't enough. Investors need to consider how the company is valued based on historical earnings and anticipated growth. A great company does not equal a great stock because all known information should already be priced into the stock. Investors make decisions on what the expect to change outside of the wide-spread expectations.
- Hold long do you plan to hold the stock? "Buy and hold" is different than "buy and forget". When buying a stock, investors should have a plan that includes a time horizon and valuation change. While paying taxes on capital gains is fun for no one, losing money on a stock that has already passed its reasonable valuation is even worse when the price reversal hits. Buying a stock you plan to hold for a long period can be fantastic, but don't forget about the stock when the reasons you bought it have changed. Those changes could be a macro-economic change or a company specific change. Ignoring your portfolio is closer to gambling than investing.
- What is your planned exit price? Once you've determined the best entry point for the stock you decided to buy, it's important to have a price goal to exit. Those planned exit prices should be lower and higher prices. If a stock price drops after buying it, it helps to remove the emotions from trading if you have predetermined limits for your losses. The opposite emotions (aka greed) can be kept in check with a price you'd be willing to sell if the stock has good growth.
- Do you understand how volatile the stock has been historically? Many stocks bounce around on a daily, weekly, or monthly basis and a quick loss could be due to a natural ebb and flow for the stock and not cause an alarm. If a stock moves suddenly in either direction it could be a signal something has changed or will soon if it's not within the stock's normal trading pattern.
- How does it compare to its 52-week high and low? Buying close to the 52-week low can be tempting with the belief it's selling for a discount now, but that price drop could be the sign of something legitimate that is pulling the price lower. If you can't find a reason other than sentiment for the price change, it might be a good buying opportunity. The reverse is true for stocks trading at or near their 52-week highs. The stock could be moving on great news, a fundamental change that makes the stock worth more or it could be due for a drop if the price increase has simply been a price/earnings multiple expansion.
- Would buying with a put option be a better choice than a limit order? A limit order allows an investor to buy on a dip, if that dip happens to fall as low as the price target. It's a great buy when an investor can time the dip near a low, but if the stock doesn't dip, the investor is left empty handed. Another route to take is to use a put option. Selling a put option gives the investor a premium (cash) as soon as the order is traded and allows an investor to make money (the premium) while waiting to see if the stock price declines. If the stock moves higher, the investor keeps the premium, but doesn't own the stock. If the stock moves lower, the investor buys the stock at a lower price than she otherwise would have if she had bought the stock initially.
- Is this stock included in any funds you already own? When buying individual stocks or new funds (mutual funds or ETFs), investors need to know if they already own the stock in funds they already own. Some investors get more exposure than they might understand by not knowing what they already own in other funds.
- How will you feel if the stock price drops 10% after you buy it? This goes back to number four above. If you expect volatility and get it, you can plan for the price drop. If you thought you were buying a certain winner, will you be tempted to sell on temporary weakness or would you consider buying more at the lower price. The answer for what is right is different for each stock and having a plan can save investors a lot of sleepless nights.
- Is there another stock that could perform better and meet your risk profile better? Any stock can go up, but is this specific stock the best one to buy for your portfolio. Could another stock be better to help you diversify? Could another stock in the same industry have a better risk/reward profile for your needs? Before buying a stock, ask these questions and if this stock helps you diversify, verify its competitors do not fit your needs better.
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