So you want to buy your first stock. That's great! After all, over the long haul, there aren't many better ways to build wealth than in stocks. Don't rush into it until you're ready, though, because money can be lost in stocks, too -- especially if you don't have a solid handle on what you're doing. Here's a seven-point checklist for buying your first stock.
1. Are you investing money you won't need anytime soon?
Remember that the stock market's long-term trend has long been up, but it hasn't moved up in a straight line. If you're going to invest in stocks, you need to be prepared to see their values rise and fall as the fortunes of the underlying companies rise and fall -- and also rise and fall for no particular reason or just because the overall market is surging or plunging. Investing in stocks means accepting volatility. Thus, don't park any money in stocks that you might need in a few years -- or, to be more conservative, within 10 years.
Be sure you can psychologically accept occasional downturns, too. Investors' performances can suffer greatly if they panic and pull their money out of stocks whenever the market heads south.
2. Do you understand the company?
A critical item on the checklist for buying your first stock is that you need to have a solid understanding of the company and how it makes its money. It's not enough to say, for example, that a company sells books. Does it do so through hundreds of brick-and-mortar stores staffed with employees, or does it do so through a website, pulling books from a few warehouses and mailing them to customers? The former business model is much more capital-intensive, as the company has to pay lots of workers, own or lease real estate, pay for utilities, keep all the stores stocked, and so on. The latter business model is "lighter" and can permit higher profit margins.
Part of super investor Warren Buffett's success lies in the discipline he employs to steer clear of companies outside his circle of competence and ones where he's not very sure how well they'll be doing in five or 10 years. We all should do the same. If you just can't get your head around semiconductor technology, consider avoiding such companies.
3. Is the company a great one?
Many investors get fixated on technical analysis, market indicators, media hype, and short-term opportunities for profit. As a result, they lose sight of whether they're investing in great companies. And they often learn the hard way that metrics, public opinion, and day-to-day market fluctuations do not make a great investment.
So what's a great company? It's one that has a combination of the following qualities: a strong competitive advantage, growing revenue and earnings, generous free-cash-flow generation, little or no debt, large (and, ideally, growing) profit margins, great growth prospects, and talented, candid management.
4. Is the stock attractively valued?
Another item on the checklist for buying your first stock is to make sure the stock you want to buy to not only belongs to a great company, but is also attractively valued. If you buy stock in a great company that's significantly overvalued, there's a decent chance that the shares will fall closer to their intrinsic value. Of course, determining a stock's true value is easier said than done. Stock analysts employ complicated formulas and spreadsheets to arrive at estimates, but their estimates will still differ from each other. You can get a rough idea of a stock's valuation by comparing its price-to-earnings (P/E) ratio to its historic average P/E or the P/Es of its peers, or by comparing its P/E ratio to its growth rate. Faster-growing companies can support higher P/E ratios.
5. Will you keep up with the company?
Another key consideration before you invest in a stock is to be sure that you're going to follow its developments and progress in the news and by reading its quarterly reports. If you don't have the time for or interest in that, consider not investing -- because you don't want a company's quality or prospects to be deteriorating without your noticing it. Regularly reassess each holding to make sure that the reasons you bought it are still valid.
6. Are you investing a reasonable sum of money?
Once you're ready to invest, be sure to be allocating a reasonable sum to a given stock. If all the money you have in the world totals $3,000, it's not smart to park all $3,000 in any stock. Even great companies fall on hard times, sometimes permanently. Don't put too much of your money at risk in one place. On the other hand, if you invest a very small sum, you're not likely to reap a big reward -- though you might keep adding money to your stock holdings over time and make up for that.
7. Do you have a brokerage account?
Finally, here's a critical part of any checklist for buying your first stock: having a brokerage account, or some way to invest in it. There are lots of solid online brokerages that won't charge you an arm and a leg to buy or sell stock. Look into them and pick one that meets your needs, perhaps such as having a local branch office or offering banking services. Many companies will also let you buy shares in them directly through a dividend reinvestment plan or direct purchase plan. You might look into whether a company of interest offers that option. It's particularly good for those with relatively little money, as it permits purchases with as little as $25 or $50 and allows you to buy fractions of shares, too. For most of us, though, a good online brokerage is the simpler option.
If you flunk the checklist
If you meet few of the criteria in this checklist for buying your first stock, buying a stock is probably not a smart thing to do at the moment. Fortunately, though, you have an excellent alternative move: Invest in the whole stock market, or a broad swath of it, via an inexpensive index fund, such as the SPDR S&P 500 ETF (NYSEMKT: SPY), Vanguard Total Stock Market ETF (NYSEMKT: VTI), and/or Vanguard Total World Stock ETF (NYSEMKT: VT). Respectively, they'll spread your money across 80% of the U.S. market, the entire U.S. market, or just about all of the world's stock market.
Index investing isn't a form of surrender. It's a perfectly sensible approach to stock investing that takes little time or energy and that will yield results that tend to outstrip those of many professional money managers on Wall Street.
Longtime Fool specialist Selena Maranjian, whom you can follow on Twitter, owns no shares of any company mentioned in this article. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.