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Don't Buy a Stock Unless You Can Answer These 3 Questions

By Maurie Backman – Sep 12, 2020 at 7:36AM

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Whether you're new to investing or have been doing it for years, you must answer these fundamental questions before adding a stock to your portfolio.

Investing in stocks is a good way to grow wealth for the long haul, and while there is some risk involved in buying stocks, doing your research can help you make smart decisions for your portfolio. But what if you're new to investing and aren't sure which stocks to start out with?

You may be inclined to simply buy stocks you've heard of, and while that's a reasonable starting point on the road to investing, you'll want to dig a little deeper to determine which companies are ultimately worthy of your money. Here are a few key questions to ask before you decide to buy a specific stock.

1. How does the company make money?

Sometimes, a company's primary revenue stream is pretty obvious. For example, if you're buying McDonald's stock, the company's business model involves selling fast food to the masses. But sometimes, the way a company makes money is less obvious.

For example, Amazon (AMZN -1.63%) doesn't just make money by selling goods online; it also takes in a lot of revenue from the subscriptions and web services it offers. It's important to buy stocks issued by companies whose business models you truly understand, so you'll need insight into how a company operates and where its revenue comes from before adding it to your portfolio.

Man at laptop holding pen

Image source: Getty Images.

2. What's the company's competitive advantage?

There are plenty of companies that do similar things or have comparable business models. But your goal should be to buy stocks issued by companies that have a true edge over the competition. Amazon, for example, has turned the act of efficiently shipping out goods into an art form of sorts, so that's one advantage it has over other retail giants. Amazon's ability to expand to different areas, from web services to groceries, also gives it an edge.

3. What might go wrong with this company?

Even great companies tend to have an underlying weakness, and it's best to figure out what those are before buying their stocks. For example, Amazon's success has been largely attributed to great leadership, but what happens if CEO Jeff Bezos steps down? Also, what if more and more retailers continue to close physical stores in favor of an online shopping model? Will that impact Amazon's bottom line? To be clear, these aren't necessarily reasons not to buy Amazon, but the point is that every company is subject to that "what if" scenario, so it's important to know what you're getting into before you buy.

Investing in stocks can be a rewarding experience if you do your research and develop a strategy that aligns with your goals and personal appetite for risk. Tempting as it may be to buy a stock simply because you're familiar with the business or use the product at hand, that's only part of the picture. You'll still need to ask the above questions to help ensure that you're putting your money into something worthwhile. That way, you're less likely to regret your decisions after the fact.

John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Maurie Backman owns shares of Amazon. The Motley Fool owns shares of and recommends Amazon and recommends the following options: long January 2022 $1920 calls on Amazon and short January 2022 $1940 calls on Amazon. The Motley Fool has a disclosure policy.

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Stocks Mentioned

Amazon Stock Quote
$92.42 (-1.63%) $-1.53
McDonald's Stock Quote
$269.89 (-0.54%) $-1.46

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