M.S. sent me this e-mail about a week ago. It is a loaded question, but really got me thinking about the stock market.

Alexander: If you folks say to learn to pick your own stocks, how do you do it? I have subscribed to the IBD for about 2-3 months now and I have not yet figured out how to pick stocks from the newspaper. I also need to learn how to read the charts before I invest. How do I do that? With so many stocks to chose from, I get confused and just end up doing nothing. Besides I really don’t have time to spend hours on the PC every day going over stock picks. So what shall I do? Are you against all stock picking services? I am sure that some research firms are legitimate. Thanks.

What you’ve asked is a loaded question. There are a million ways to pick stocks, and everybody has a different answer. So I’ll take my own crack at it. Please remember, though, that I’m just an amateur investor and not a financial advisor.

The way I see it, there are three possible paths someone could take to pick stocks.

#1: PEOPLE BUY STOCKS BECAUSE SOMEONE ELSE SAYS TO BUY.

This covers the majority of people in today’s stock market. Whether you got the idea to buy from SmartMoney Magazine, your uncle, or your favorite primate’s stock-picking service, most people don’t understand stocks. So they usually buy a stock when someone tells them to.

This might work sometimes – heck, it works a lot of the time – but there are a few problems with this strategy.

1. A lot of people might be “listening” to the story. The guys on CNBC can move stock prices. That’s not necessarily because they picked a great investment, but because people that listen often buy. I’m not against any stock picking services, but I think they can be misleading; if everyone on Wall Street subscribed to their service and did what they said, who would profit?
2. You might not understand the story. Are you familiar with the company’s business? Do you know how they make their widgets, and how their business could be affected by everything in the news? A thirty second soundbyte is not the same as reviewing a year of 10Q and 10K filings.
3. There might be “cracks” in the story. Your resource might have analyzed the company’s discounted cash flow or noticed that it was highly leveraged. But it might not have, and so there might be things about the company you don’t know.

How could I do something so foolish–taking the advice of someone who calls himself the Gorilla? … I have no idea why I purchased the damn stock in the first place. And this is galling because it makes me feel helpless. I mean, I’m not even making my own mistakes. I’m making someone else’s mistakes.
-from “Just Monkeying Around” by Andrew Feinberg, Kiplinger’s Personal Finance, May 2004

4. If the story changes – when will you find out? The company might report a great deal in the works. But it could say that its largest wholesale customer just fired them. When you are following their story, news like this could signal a time to buy – or it could mean you should sell. So, the million dollar question is: who is keeping their finger on the pulse of your investment? Do you keep an eye on these factors? And, if you follow someone else’s advice – do they?
5. There is a lot of uncertainty. Since you may not understand why the stock is a good buy, you might have even more difficulty understanding it if you see it drop in price. If you are overcome by fear, you might unload it just before the market sends it soaring. Can you handle the idea that you might never feel calm and confident about what is happening to your investments?
6. When do you sell? Investing is all about buying low and selling high. But if you don’t understand the company and its business, you might never know when things are too good. If you wait until the folks on TV tell you, you’ll probably be selling too late. Some investors wait until it drops, and others sell when they believe it is overvalued. But if you buy just because someone else tells you to, you’ll probably never know when to sell – because you never understood why to buy in the first place.

#2: PEOPLE BUY STOCKS BASED ON TRENDS, MOMENTUM, AND TECHNICAL INDICATORS.

This could mean it has an upward trend, its candlestick charts look great, it is below its moving average, or that an alphabet soup of technical indicators all point to the stock. The big picture is the same – some people invest based on what they believe the market is telling them about one particular stock.

This also works – hedge funds and day traders make a living of this type of analysis. But there are a few problems, too:

1. The indicators can change quickly. Hundreds of millions of shares trade each day. Most active traders are tuned in to the market continuously.
2. To excel, you must really understand it. If you want to work with candlestick charts, you need to understand the reversal patterns, what they are telling you, and which ones are more reliable than others. If you look at price and volume data, you need to understand what the data is telling you so you can take immediate and decisive action if necessary. That is not impossible – plenty of people make money doing this type of analysis – but it will take time and effort.
3. You’ll spend more in fees. Depending on the data you’re looking for, you might need access to additional market data. You’ll also be trading stocks more often. This will cost you more; but it is a moot point if you’ll be making more money.
4. The more trades you make, the more mistakes you are likely to make. Let’s say that you were the world’s greatest investor, and that every time you made a trade, there was a 99% chance you were right. That also means there is a 1% chance you were wrong per trade – and, after five trades, it multiplies to a 5% chance you were wrong. This statistical probability of error can build quickly if you are trading every day.

#3: PEOPLE BUYS STOCKS BASED ON PRICE VERSUS PERCEIVED VALUE.

This applies to anyone that looks at a stock, understands it enough to think it is worth more than its current price, and then buys on that reasoning. Some people perform an in-depth analysis of the company’s discounted cash flow, and some people just look at the Price to Earnings (P/E) ratio.

Some people focus on industries that they understand – like restaurants, or pharmaceuticals, etc. It helps if you understand the industry you are investing in because you might have some inside knowledge into the companies you work with. A pharmacist, for example, should invest in pharmaceutical companies and health care businesses because they have inside information the average guy on Wall Street doesn’t have: they know what customers are buying, what pills have bad reactions, and the ‘latest drug’ that area doctors are prescribing. With that kind of industry information staring them at the face every day, why should a pharmacist buy stock in Cisco systems?

Buying what you know about is a very sophisticated strategy that many professionals have neglected to put into practice.
–Peter Lynch, from “One Up On Wall Street”

Other people use screens to come up with a starting list of stocks. One good resource that I use is Morningstar, which has a great stock screener. I also recommend checking out the American Association of Individual Investors (aaii.com).

One screen I use from time to time is John Dorfman’s “Robot” screen. He looks at several criteria, but the last is that he takes the stocks with the lowest P/E values. For more info, see “Robot Portfolio Chugs to Fifth Straight Victory” (PDF).

There is a whole style of investing that fits in this box called “Value” investing. It takes the idea of investing and makes it academic instead of emotional. The whole goal here is to buy stocks at a discount to their value – things the market has not figured out yet. This is the style that Warren Buffett, his mentor Benjamin Graham, and a large number of successful money managers use. Warren Buffett has argued that it is the most successful style of investing.

There are problems with picking stocks this way, too:

1. There is a lot to read and understand. Not everyone can or is willing to commit the time to it.
2. There is a lot of data to sift through. There are lots of screens out there. Some magazines have new screens in each issue. I used to read a month’s worth of personal finance magazines and have dozens of stock ideas to research, and I used to change my screens constantly. You also have to read company filings, look at their balance sheet and cash flow statements, and make sense out of them. This is not easy – but, once you know what to look for, it really isn’t that hard, either. Warren Buffett can do the numbers in his head, and I think this gets easier with experience.
3. Depending on how you come up with your “perceived” value – you could be wrong. Of course, you could be wrong no matter how you pick a stock – unless you buy with a margin of safety.

If I could suggest two books for you to read, they would be:

1. One Up On Wall Street by Peter Lynch
2. The Intelligent Investor by Benjamin Graham – be sure to get the 4th edition with commentary by Jason Zweig.

The first is an easier read than the second, and will give you a lot of ideas on how to pick stocks. The second, however, is Warren Buffett’s favorite investing book, and is definitely worth a read too.

Investing requires work. Successful investors buy things when they are out of favor – so if you don’t have time to think about what could be out of favor, perhaps you shouldn’t be investing?

I’m not against any stock-picking service, but it is my opinion that a stock picking “service” can only get you so far. When you lose money, it will be because you made a decision that wasn’t even your own. And when you do gain, you won’t even understand why – so you have little chance of repeating that performance again and again.

Buying stocks is about taking the time to make clever and educated decisions weeks, months, or years before the chumps on Wall Street come to the same conclusion. By using a stock picking “service”, you are taking away one of your most powerful tools – your brain.

If you can’t spare the time to read a few books, learn a few things, and make educated decisions about your nest egg – you shouldn’t be trying to invest it in individual stocks. Instead, you should put your money into an index fund and hope you can get 10% every year like the rest of the mainstream.

At the end of the day, each of us is on his or her own path. No one knows where we will all end up, but they will all be different places.

But remember, there is no easy path to riches. How many billionaires do you know? How many of them became wealthy by joining a stock-picking service?

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