How do investors choose which stocks to buy?

Plus: The difference between passive investors and active investors

How do investors choose which stocks to buy?


By Jonathan Russell

Choosing the right stocks to buy can be a great way to help you grow your wealth. But like any investment, there are a lot of risks involved. So how do investors decide? Here are the basics that may help you become a successful investor.

How do investors choose which stocks to buy?

If you are interested in entering the world of stocks, it is a good idea to familiarize yourself with the basics. To start, a stock is a partial share of ownership in a company. A share is a unit of stock, which are most often traded on stock exchanges such as the NASDAQ and the New York Stock Exchange, or NYSE.

The price of a stock is generally determined by the number of buyers versus sellers, or supply and demand. The price of a stock increases if there are more buyers than there are sellers. On the other hand, the price will drop if there are more sellers than there are buyers.

This means that the stock price of a company is measured by how much investors think the company, or a part of the company, is worth. In other words, investors just need to have faith that a company will be profitable eventually – in fact, a company does not actually have to make a profit to be valued by the market. And depending on public perceptions, stock prices can rise and fall quickly and drastically, because of the speculative nature of stocks.

Investors stay up to date with the following:

When determining which stocks to buy, investors must be well informed and remain up to date on numerous economic and market changes. The reason this is so critical is that these factors can have a direct impact on a company’s earnings. In other words, your decisions will be improved if you have reliable, up-to-date information.

For commentary on the Australian economy, you can stay up to date on the Reserve Bank of Australia’s quarterly Statement on Monetary Policy; for new economic information, you should read the business and financial sections of reputable magazines, newspapers, and websites; and for a forecast of economic conditions, you should research departments of stockbrokers and banks.

More broadly, you should also be educating yourself on interest rates, the Australian economy, exchange rates, government policy, regional or industry-specific influences, investor sentiment, and relevant overseas markets and economies.

The difference between passive and active investors

There are two main styles of investing that can help dictate how investors choose what stocks to buy. Those investing styles include:

Passive investors: These types of investors track the market closely, meaning they usually hold onto their stocks in the belief that over a longer period, the stocks’ value will increase.

Active investors: Active investors usually attempt to beat the market by buying shares they think are undervalued, all with the intention to sell their stocks after the prices go up again.

A lot of investors tend to actively manage their stocks, despite the risks involved or maybe even because of them. To figure out a company’s possible value, and ultimately to suss out undervalued stocks, active investors usually investigate a company’s business operations, review a company’s financial statements, and track price trends, hoping to find a company that is undervalued. Active investors also tend to put money in actively managed funds or just hire a financial planner to do their work for them.

In the last decade, active investors have had the potential to earn a lot more money, but passive investors have usually shown higher returns.

What do stocks do?

Unless you have extensive knowledge of how a company earns its money, you should avoid buying a stock. In other words, what does the company manufacture? What kinds of services does the company offer? In which country does the company have its base of operations? What is the company’s flagship product? How is that product selling and in which markets? Is the company a leader in its field? These are the types of questions you should know the answers to before you buy a share in a company.

While there is a lot to learn, the information should be very easy to find. Most companies can be found and studied by using a quick Google search and combing through their company website. As an exercise, you can then go to someone in your life and tell them about your potential investment. When you are able to answer any questions they have about the investment and company, you should have the extensive knowledge required to buy stocks.

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