Whether you are a novice investor or Warren Buffett, identifying quality investment ideas can be a challenging endeavor.
A seemingly endless number of financial services providers offer big promises to help you find the next hot stock. And everyone has that one cousin or overzealous neighbor who is always pitching the "next big thing."
Unfortunately, most of the time, more bluster than brains is behind many of these ideas.
Here are a few tips for crafting a reliable process for identifying investment ideas.
First, build an emergency fund
I'd be remiss if I didn't start with a few words of caution.
Life has a way of throwing curveballs, such as unforeseen medical expenses or a job loss. Before investing in the capital markets, most personal finance experts recommend building an emergency fund of roughly six months' worth of expenses.
It is good practice to keep this account separate from your normal investment portfolio.Should a rainy day strike, having an emergency fund can help you avoid selling investments at an inopportune time simply because you are in a bind.
Next, establish an index fund
Before dabbling in individual securities, some sage advice is to make your first investment a low-cost index fund.
Why? There has never been a more powerful growth engine than the U.S. economy. Giving yourself exposure to a broad range of companies, across a variety of industries, is a good first step in establishing any portfolio. Index funds can save you time, reduce headaches, and help to anchor your portfolio for long-term success.
Those who want exposure to a particular theme can invest in exchange-traded funds (ETFs) and mutual funds structured around specific sectors (such as technology or healthcare) and even sub-sectors (such as cloud computing or biotechnology).
Read more: How to Invest in Index Funds
Use stock screeners to generate ideas
Now the fun part. Picking individual stocks comes with more risk, but it can yield outsized returns if done correctly (and patiently).
Stock screeners like the one Finviz offers for free are a great way to identify potentially attractive investments. There is not just one "correct" way to make stock purchase decisions, but here are a few potential parameters to consider:
- Market capitalization
- Revenue growth rate
- Gross margin
- Price-to-earnings ratio
- Enterprise value/EBITDA
- Inside ownership percentage
It's important to note that financial metrics alone can be deceiving. For instance, just because a company is inexpensive on a price/earnings basis does not necessarily mean that it is a good investment. And, a company growing significantly in the past does not guarantee it will continue to do so in the future.
It is also important to understand a company's business model and the competitive landscape before investing.
Read, then read some more
There is a reason that some of the best investors in history have been voracious readers. Consuming content, whether it's educational, news-oriented, or opinion-driven, can help to broaden your perspective and shine a light on trends about which you may be unaware.
Participating in online chat rooms filled with like-minded individuals is another great way to generate investment ideas and keep abreast of the market. Not even the most sophisticated investor can keep tabs on all the activity occurring in the stock market. Chat rooms can help to spread the workload among dozens of people who each watch individual stocks and relay pertinent information to the group.
Simply look around
This may be the most powerful way to generate quality investment ideas. Many of the companies with the best-performing stocks have evolved their products and business models in plain view of the consumer:
- Apple (NASDAQ:AAPL): In the early 2000s, you didn't need to be a software engineer to pick up on the popularity and innovation of Apple's iPod.
- Netflix (NASDAQ:NFLX): The creative lightbulb guiding Netflix's early business model, no matter how rudimentary at first, paved the way for its future as a streaming service and one of the most disruptive companies in the history of the modern economy.
One of the greatest investors of all time, Peter Lynch, says that he has gotten several of his best investment ideas from his wife and children. He encourages investors to simply open their eyes, observe the world, and invest in their respective circles of competence.