Beginner investors often struggle with figuring out how to pick companies to invest in. Here’s what the financial experts say.
You’ve probably heard investing success stories from friends, colleagues, or even the news about people who took a bet on a company and profited handsomely several years later.
One major case in point: Southwest Airlines. Anyone who invested $1,000 in the budget airline in 1990 with their dividends reinvested would have $54,000 today.
Of course, picking good companies to invest in is far easier said than done. With so many new innovations and startups on the rise, how do you separate safe investments from risky ones?
Here’s how to pick companies to invest in, according to the experts.
1. Ask yourself these key questions
“Having a portion of your portfolio to invest in individual companies is a fun way to support companies you have an interest in,” says CFP and financial coach Alexandra Wilson. Of course, it also requires financial prudence.
When considering prospective companies to invest in, Wilson advises her clients to run through the following questions:
- How does this fit into your overall portfolio?
- Are there special causes or interests you want to support?
- Is the company priced fairly? Is their price-to-earnings ratio in line with other companies in the industry?
- Are you willing to earn less of a return if this company is a special cause/interest?
- What do the company’s financials look like? Is their revenue and bottom line reasonable and sustainable?
- What is your exit strategy? Would you like to hold on to this long-term, or is there a price point that you would like to sell it at?
Use these questions as guideposts when making an investment decision. Wilson also recommends that investors diversify their portfolio by investing in “many companies and between stocks and bonds—best done through mutual funds or ETFs, and aligned with [their] goals and risk tolerance.”
2. Invest in what you know
There’s a reason why legendary investors like Peter Lynch and Warren Buffett advise beginner investors to “buy what you know.”
Understanding a company is a must before deciding whether or not to invest in it. This makes sense—if you don’t understand what exactly a company does or how it makes money, why would you put money behind it?
Along the same lines, Sharif Muhammad, CFP and founder of Unlimited Financial Services, encourages clients to consider the products and services that they engage with regularly. “Chances are,” he says, “the companies that you love have great businesses and are very profitable.”
Muhammad also shares how it doesn’t take incredible knowledge or keen insight to practice this simple tip:
“A few years back (2016), my 8-year-old picked a handful of stocks as part of a school project. When asked what to invest in, I told her to think about what she uses every day. She invested in Amazon (AMZN), Panera (PNRA), and Disney (DIS). Over a six-month period, she did very well—over a 24% return!”
3. Check free annual reports from the SEC
The U.S.’s Securities Exchange Commission (SEC) is an independent agency that essentially acts as a regulatory watchdog for investors. As part of its mission to protect investors, it requires public companies and other regulated companies to file annual reports.
These documents contain a goldmine of insight on a company’s performance, including:
- An overview of the company’s work and industry
- Financial statements, such as the company’s balance sheet, income statement, and cash flow statement
- Management’s discussion and analysis of the company’s financial status
- Auditor’s report
Why do these annual reports matter?
The SEC maintains a public database called the Electronic Data Gathering, Analysis, and Retrieval (EDGAR) system that contains these reports—and you can easily access it for free on the SEC’s website. These documents offer valuable insight on a company’s financial performance, and can help you better understand the companies you’re thinking of investing in.
4. Play it safe with the S&P 500
Intimidated by the thought of picking individual stocks and companies to invest in?
Fortunately, that doesn’t mean you have to give up on investing altogether. Instead, you can play it safe by investing in the S&P 500—a strategy famously praised by the likes of Warren Buffett himself.
Considered one of the best representations of the U.S. stock market, the S&P 500 (short for “Standard & Poor’s 500 Index”) measures the stock performance of 500 of the U.S. stock exchanges’ largest publicly traded companies. Among these companies include Microsoft, Facebook, General Electric, Disney, and plenty of other familiar household names.
Many financial planners advise new investors to start out with an S&P 500 mutual fund or ETF, as the index represents 80% of the U.S.’s market capitalization. Such an investment can be thought of as a bet on the American economy, which has performed well historically—in fact, its average annual return over nearly the last century is 10% before inflation.
5. Get educated on investing and stay up-to-date on the news
Becoming a confident investor doesn’t happen overnight. But intimidating as investing can be, the main barrier to entry is knowledge and expertise.
Fortunately, plenty of free and easily accessible resources about investing, current events, and the market exist. To stay in the loop, consider:
- Signing up for email newsletters about the global economy, like Finimize and the Quartz Daily Brief
- Listening to personal finance and investing podcasts like We Study Billionaires and Stacking Benjamins
- Following online blogs and news
- Creating relevant Google Alerts
- Downloading finance and stock market apps like the Bloomberg Business App and Marketwatch App
Whatever your preferred method of content consumption, you likely have plenty of options. And the sooner you start keeping tabs on financial and economic news, the better you’ll be able to understand the market and identify potential investments.