5 Questions to Ask Before Buying a Stock
Here's how to efficiently research a new investment idea.
Justin Davis
December 12th, 2022
Blog | 5 Questions to Ask Before Buying a Stock
tl;dr
Some investors buy too quickly. Some get mired down in research. Here's how to thread the needle.
How much risk can I take?
Does this fit within that boundary?
Is it correlated with my portfolio?
How much should I buy?
When should I sell?
Here’s what the decision process looks like for too many investors:
Hear about a Hot New Stock!
Buy the Hot New Stock!
That’s it.
Venture too far in the other direction, though, and you get permanently mired in the decision-making stage.
Here’s a checklist to reference next time you get interested in a new investment (and remember that this works for a stock, an ETF, crypto—anything you’re considering putting your money into.)
1. “How much risk can I take?”
Every investment carries risk. (Even the “sure bets.” Probably more so, actually.)
And risk tends to throw a wrench into decision-making. When you find yourself in a position where you’re taking on more risk than you’re comfortable with, you’re more likely to make mistakes in buying and selling, and more apt to overreact to daily fluctuations in price.
To combat this, determine how much risk you can tolerate. Ask yourself: “If I lost $100 on this bet, would I be OK? What about $1,000?”
You don’t need to be exact here, but knowing where your boundaries are will help you to choose investments that are likely to respect that, meaning that you’ll have less anxiety knowing that your investments are on par with what you feel like you could handle, should the worst case happen (which it sometimes it does!).
2. “How much risk am I taking with this investment?”
So now you know your risk boundaries. Next, ask: does this fit within that guideline?
There are a few ways to assess the risk of any investing idea. First are the qualitative questions:
Is this a brand new company, or one that has some track record? More track record = less risk of the unknown.
Is anyone else successful investing in this? Using a website like Whale Wisdom, you can check to see what (if any) professional investors are investing in the same thing. While not a guarantee of success, more pro investors taking bets on the same investment can help to identify opportunities that may be less risky than ones where few people are kicking the tires. There is, after all, some wisdom in crowds.
Then, look at the numbers. In the first step above, you landed on a dollar value for your risk tolerance. So the question is, does this stock or ETF or crypto you’re considering bust that limit?
Finiac’s dScore can help—it tells you what you should expect to lose with that asset on your worst day in any given month. We use it in the app and on each of our symbol pages.
Make sure the dScore sits inside your risk tolerance, and you’ll be far more likely to withstand the ups and downs that will inevitably come.
3. “How correlated is this with my portfolio?”
Correlation between two different assets simply means that they move together—they tend to rise at the same time, and drop at the same.
In your portfolio, highly correlated assets tend to increase the risk in your portfolio, because it’s more likely that the whole thing will drop all at once. Your daily movements tend to be amplified, creating larger swings.
Reducing correlation lowers risk, because you’re a lot less likely to take a huge hit all at once.
To find out how correlated two positions are, you can compute this by hand, or you can test your portfolio in Finiac, and we’ll do it for you.
4. “How much should I buy?”
When you’re thinking about pulling the trigger on a new investment, how do you know how much of it you should buy? Should you buy as much as you can afford?
It depends!
Remember that in a portfolio, the relative weighting between positions has a big impact on how well that portfolio does. If you have more of your portfolio invested in riskier assets, the end result will be tilting your portfolio toward a riskier, more volatile return. If you have a majority invested in more stable assets, the opposite is true.
When you’re trying to identify how much of a given asset to invest in, ask yourself:
“How risky is this asset compared to my portfolio, and am I trying to increase, or decrease my overall risk?”
(Here’s a tip: you can compare the dScore of any asset to your portfolio’s dScore in Finiac to see how risky an asset is compared to your portfolio.)
5. “When will I sell?”
The greatest investors in the world know when they’ll sell before they ever hit the buy button. This is the varsity level of risk management for independent investors—which is odd, because it’s actually not that hard to do. And it helps you avoid the most common mistakes—like holding on longer than you should.
How you’ll determine when to sell is totally up to you. Here are a couple methods that we find useful for establishing your boundaries:
Use trailing stops. Trailing stops are like alarms that go off when your investment has dropped by a certain percentage amount. This ensures that you don’t lose more than you planned on, should things go against you unexpectedly.
Determine a price target. Think of an investment like a player on a team. They’re in the game to help you advance something, so define what you want out of them. Do you want a position to double before you take profits off the table (a strategy that allows you to recoup your investment and play with house money)? Or, perhaps you’re using technical analysis, and are eyeing a plateau in the future. Either way, determine what you want to hit and write it down.
Having a short checklist of things to consider when making a new investment will help you make smarter decisions about where to put your money, and lead to more clear expectations about what you want that investment to do in your portfolio.
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dScore - A metric describing the amount you can expect to lose on an investment on your worst day in an average month. Equal to an asset’s 95% value-at-risk.
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