Investing in the stock market is certainly one of the best ways to put your money to work. Stocks have been the best-performing asset for a long time, and it is only natural that it keeps attracting investors’ funds. But what do you need to consider before investing?
In this guide, we will go over the 20 most important factors to consider before investing in the stock market.
What factors do you need to consider before investing in stocks?
Before you even start looking for stocks to invest in, you need to make sure you are prepared to make investment decisions. There are a lot of factors that need to be considered to make the right investment. Here are some of the most important things you need to consider:
- Financial goals
- Set your limit
- Risk tolerance
- Investment horizon
- Investor profile
- Market valuation
- Investment strategy
- What is the expected return
- Are you diversifying?
- Have you done your research?
- What will your portfolio exposure be to this stock
- Financial situation
- What can go wrong?
- Understand that markets can be irrational
- Risk-return profile
- Type of portfolio management
- Leverage is a double-edged sword
- Are you trying to time the market?
- How liquid is this investment
- Leave Your Emotions Aside
1. Financial goals
Your financial goals should be one of the most important factors to consider even before you invest. Early on, it is important to define exactly what your financial goals are. Do you want to save and invest for retirement or are you looking to take risks in order to have large returns?
Answering this question will help you to put everything into perspective, and it should help guide you on what type of investments you should be analyzing, and researching.
Some investors are willing to take a lot of risk in order to achieve their goals and others aren’t. Their goal is to beat the market and achieve superior returns. This is also something to take into consideration.
2. Risk tolerance
One of the most important factors to consider before investing in stocks is to access your risk tolerance. Not every investor has the same ability to deal with losses. Therefore our investment portfolios should reflect how we feel about risk.
This can prevent you from investing in volatile stocks, that could lose their value.
3. Set your limit
The stock market is a wealth creation machine, but that does not mean that investors always make money. Losing is part of every investor’s life since you are not right every time. Knowing this, you need to set your own investment limit.
How much are you willing to lose?
If you are willing to lose more money, perhaps your risk appetite is higher, and so are your financial goals. In this case, you may be looking for growth stocks and capital accumulation investments.
Conversely, if you want to protect your capital, you should stay with defensive investments. There are plenty of different investment strategies focused on capital preservation if you are more risk-averse.
You want to make sure you set a limit for each investment that is cohesive with your risk profile, and that it also puts you on the right path towards achieving your financial goals.
4. Investment horizon
Your investment horizon will also be an important thing to consider before investing.
When will you need the money you are investing in today? A year from now? Or 30 years from now?
This is will determine the amount of risk you should take, and the kind of investments you should be making.
While a high-growth stock might be appropriate for someone that has a 10 or 20-year investment horizon. It is not the best investment if you need the money to buy a house or a car for example.
If the time horizon of your investment is shorter than 3 years, you should put your money in the safest assets. If your risk tolerance is a little higher, you might even consider investing in defensive stocks.
These stocks tend to have stable prices and pay dividends. You can use this additional income your portfolio will generate, to balance potential losses.
5. Investor profile
Another important factor to consider is what is your investor profile like. Although the investor profile takes into account your risk profile, investment preferences, financial goals, and investment time horizon, it also focuses on your current financial situation.
This helps you to determine the type of investments you are more inclined to make.
While some individuals are able to day trade and deal with the stress of market fluctuations every day, some investors prefer to invest safely for the long term even if their returns are lower.
Before investing you need to understand exactly what type of investments you should be looking for based on these factors.
We have a great investor profile questionnaire that can help you determine your investment profile.
6. Market valuation
When you start looking at different stocks, you might not know exactly which ones you should pick. Is stock picking just luck, or what is driving large institutional investors to make certain investments at a certain time? Well, one of the main market drivers is market valuation.
The market as a whole can be valued, similarly to the way individual stocks are valued. This allows you to compare a business valuation to the broader market.
Here are some of the most important market valuation indicators that you should pay close attention to:
7. Investment strategy
Another thing to consider before making investment decisions is what is your investment strategy. Some retail investors are short-term focused, and would rather take advantage of small stock price fluctuations than hold stocks for a long time.
Long-term investors will also choose different strategies based on their investment preferences.
Some investors use a growth investment strategy, that is based on buying stocks in growth companies. Other investors take a value investing approach, based on buying stocks that are trading below their intrinsic value.
You need to define your investment strategy before you even start analyzing stocks.
8. What is the expected return?
With each investment opportunity, you analyze you should be able to pinpoint exactly what the expected return is for that asset. Calculating expected returns is a mix of science and art, and it is not always accurate.
Financial analysts will create financial models for each stock they analyze trying to determine exactly what returns they can expect. However, every financial model has a set of assumptions, that might or might not materialize.
This should not deter you from trying to understand what kind of returns you can expect from a certain stock. Stocks return on average 10% a year, and it will also be helpful to look at the historical returns of the company.
Additionally, you want to go through the financials and determine the growth rate of the company, and if it will continue in the future. Make sure you give yourself some margin of error because not even the most successful financial analysts are always right.
9. Are you diversifying?
You also want to consider your current portfolio allocation. Are you diversifying your investment portfolio?
When considering a stock you need to understand how it will fit in your portfolio. If your intention is to diversify your portfolio, you need to avoid these two common situations:
- Related diversification: When you invest in stocks in the same industries.
- Diworsification: Investing in worst companies than the ones you already own.
For the majority of investors, it is important to keep a diversified portfolio, that allows you to achieve your financial goals, while also reducing volatility and risk. However, you should also be aware that there are clear advantages to running a concentrated portfolio. The volatility and risk of a concentrated portfolio also tend to be higher, and this type of portfolio is more appropriate for experienced investors.
10. Have you done your research?
Investing in a stock without properly researching is one of the most common mistakes investors make. You have to make sure you due diligently research each company.
By understanding a company's financials, an investor can get a sense of whether the stock is overvalued or undervalued. Additionally, research can help investors understand a company's competitive landscape and how it might fare in the future.
It also allows you to understand exactly what are the potential risks with the stock.
11. What will your portfolio exposure be to this stock?
Another thing to consider before investing in your portfolio exposure to the stock. Are you investing a large percentage of your portfolio in a single stock? Do the expected returns justify a large allocation to your portfolio?
You want to avoid allocating too much of your capital to a single idea unless you are completely sure that it will be a winner.
12. Financial situation
Your financial situation should also be considered before investing in the stock market. Are you in debt? How is your professional career going? Are you expecting any large expenses in the next few years or months?
These are some of the questions you need to consider before investing. If you are in debt, you may want to avoid risky and volatile stocks. The same goes if you have an unstable job, or if you are expecting large expenses in the short term.
When making any decision about money, it is important to consider your financial situation. This includes your income, debts, and other assets. It is also important to think about your goals for the future and how investing might help you achieve them.
If you are not comfortable with taking on any risk, you may want to stick with safer investments. But if you are willing to risk some of your money in order to potentially earn a higher return, you may want to explore more volatile options.
Each stock has different risks associated with it, as an investor you need to consider each and every risk. Understand what can go wrong with the company, by creating different risk scenarios.
Once you have narrowed down those potential scenarios, you have to estimate the likelihood of happening. The future of a company is nearly impossible to predict, but it is possible to make an accurate estimate.
Try to also identify the potential industry risks, that could influence the returns. One way of doing so is by talking with an industry expert, that will be able to explain to you how the industry works, and the potential challenges your investment might face.
14. Risk-return profile
Once you have calculated or projected the expected returns, and the risks it is now time to understand the risk-return profile of the stock.
Ideally, you want to look for stocks where your potential returns outweigh the risks. So, in the best-case scenario, the returns would be a lot more than the potential losses. Some of the most successful investors are able to do this consistently.
It is one of the reasons the more prominent investors are value investors. They focus on companies where the potential upside might not be very high, but the downside is insignificant.
15. Type of portfolio management
Another decision you have to make before investing is whether you want to have passive or active portfolio management. If you do not want to dedicate a lot of time to researching stocks, and checking financial news, you should take a passive investing approach.
However, if you are able to dedicate some time to stock research, and monitoring stock prices you might consider actively managing your portfolio. Even if you want to manage your portfolio actively, you may not want to spend every day thinking about it, and this will also influence the type of stocks you will be looking for.
16. Understand that markets can be irrational
Something you need to consider before investing is that markets can be extremely irrational. This means that stocks can fluctuate a lot in price, and you need to be able to deal with extreme events without panicking and selling your stocks.
Decisions fueled by fear could pose a tremendous risk to your investment portfolio. For this reason, you need to accept and embrace the volatility, and even take advantage of it, by buying stocks at lower prices.
17. Leverage is a double-edged sword
If you are considering using leverage to invest you need to be well aware of the risks associated with leverage. Leverage can boost your returns, but margin can also put you in debt if you do not know what you are doing.
18. Are you trying to time the market?
While it is possible to time the market in some instances, you know what they say - time in the market beats market timing.
Unless you are an extremely experienced investor or trader you should avoid trying to predict what the market will do. This often ends up leading you to make decisions that will hurt your portfolio and your returns.
19. How liquid is this investment
Liquidity is extremely important, especially when it comes to stocks. If you want to make an investment in an illiquid stock, you need to make sure you plan on holding the stock for the long term.
If you will need to sell your investment in the short term, you want to stick to highly liquid stocks.
20. Don’t get emotional
Finally, one of the most important things to do during the whole investment process is to avoid being emotional. When it comes to investing, emotions can deeply influence your decisions and force you to make bad decisions.
Greed and fear, also have a great influence on how we feel, and this could lead us to make the wrong investment decisions. You also need to avoid making any impulsive decisions.
Every investment decision needs to be carefully considered and evaluated.
When you start investing you may feel overwhelmed with the amount of information it is available on the subject. Make sure you take these things into consideration before making any investment decisions.
Always do your research, and if you are unsure what to do consult with an expert, and remember to always stay diversified.