Investments are intoxicating mixtures of risks with the potential for varying degrees of reward. Successful investors learn to balance the two to find a middle ground where they enjoy modest investment returns. Some are more wildly successful than others. Ultimately, creating an effective strategy to minimize risks while maximizing potential rewards requires much research on the front end of your investments. As an investor, you owe it to yourself to perform a certain amount of “due diligence” by researching where you will place your money. Fortunately, there are many tools you can use to help you do exactly that.
Understanding Your Investment Goals
Before determining which stocks, bonds, etc., are good investment choices, you must understand your overall investment goals. What do you plan to do with the income generated from your investment? Are you hoping to retire on the funds? Do you need to generate recurring income? Do you want to use the gains to fund other investment opportunities? Are you planning to purchase real estate? Do you hope to buy a business? Are you considering starting a business of your own? Are you just trying to pay off debt or send your children to college?
Understanding your goals helps you identify whether you need investments that offer short- or long-term returns and how much risk you can afford or need to take to achieve a specific return. Knowing these things lets you develop a strategy to help you achieve your current and future investment goals.
Basic Investment Research Tools
If you’re considering investing in companies, you’ll want to sneak a peak at the company's 10-K, its annual report that provides an overall snapshot of the company’s financial well-being, as well as the 8-K report that companies must file any time a decision is made that requires or warrants a financial disclosure. This form provides a more “up to the minute” report on the organization’s financial health than an annual report. Most mutual funds offer a prospectus for potential investors that includes a wealth of information. The FINRA Fund Analyzer offers additional reports on mutual funds, exchange-traded funds (ETFs), and exchange-traded notes (ETNs). There are other tools to consider, depending on the type of investment you wish to pursue. Finding the proper research tools to help you learn more about your investment of choice won't take too much research.
Key Financial Metrics and Ratios
Understanding specific metrics and ratios can help you accurately assess a company's financial health and suitability as an investment option. Here are some essential terms to familiarize yourself with:
- Revenue: This is the income a company earns over a specified period. Focus mainly on the operating revenue, derived from the sale of products, rather than non-operating revenue, which comes from the sale of assets and other ancillary activities.
- Net income: This represents the total profit of a company, calculated after deducting all operating expenses.
- P/E (Price/Earnings) ratio: This is calculated by dividing the current stock price by the earnings per share over the most recent 12 months.
- EPS (Earnings Per Share): This measures the portion of a company's profit attributed to each outstanding share of common stock, helping to indicate a company's profitability.
- Debt-to-Equity Ratio: It indicates the relative proportion of equity and debt the company uses to finance its assets and signals its financial leverage.
- Operating Margin: This ratio is used to measure a company's pricing strategy and operating efficiency - a higher operating margin indicates that the company has lower fixed costs and better performance at its core business.
- Current Ratio: It measures a company's ability to pay its short-term liabilities with its short-term assets - a current ratio greater than or equal to one indicates good financial health.
- ROE (Return on Equity): This assesses a corporation's profitability concerning stockholders’ equity. It measures a company's financial performance by identifying the net income returned as a percentage of shareholders' equity.
- Free Cash Flow: This reveals the net amount of cash after a company has met its operating, investing, and financing obligations.
- Price-to-Book (P/B) Ratio: It compares a company's market value to its book value, helping investors identify undervalued stocks.
- Dividend Yield: If a company pays dividends, the dividend yield can be a significant indicator for income-focused investors.
These are just a few metrics and ratios that can offer insight into the potential returns on your investment. However, it's important to remember that investments are inherently risky, and various other factors can significantly influence the outcomes.
Role of Economic Indicators
Do not overlook economic indicators; they serve as vital tools in forecasting the potential future success of specific investments. However, remember that these are merely indicators, susceptible to change, and should not be used in isolation from other information. Despite this, they can help identify trends, pointing you towards investments that may be safer than others.
Importance of Market Trends and Investor Sentiment
Market trends and investor sentiment can abruptly alter your investment landscape, driven by continuous news updates through social media and 24-hour news cycles. For instance, wildfires in a distant location can influence the sales of fireproof safes and fire-retardant insulation elsewhere. Therefore, it is vital to monitor market trends vigilantly and prepare to withstand potential downturns patiently or sell promptly at the initial signs of instability.
Creating a Diversified Portfolio
Diversification is the most important thing you can do with your investing efforts to shield your current and future financial health from much of the volatility a fickle market delivers. The more diversified your portfolio is, the less painful the impact of a sudden downturn in one or even two sectors will be – as the rest of your portfolio is in other sectors and types of investments.
Avoiding Common Mistakes
One of the biggest mistakes you’ll want to avoid is analysis paralysis. You become so caught up in the analytics that you fail to invest. The other mistake is conducting no research and making investments based solely on how the company or products the company produces make you feel. It might make you feel good, but these investments rarely result in positive financial returns.
Takeaways
Research is a tool that can enhance your return on investment if you trust proper sources and use the information wisely. These tools can help you accomplish your investment goals.