So you’ve found some interesting investment ideas and you are sure you’re investing a company you understand. That’s great … but before you do anything else, you need to make sure this particular stock is actually the kind of investment you should even entertain as a novice investor.
Remember: Many investors are motivated by greed and profits above all else. They don’t mind taking on big risks if that means big rewards. But for frugal investors, limiting losses to protect your money is just as important as growing your nest egg. You don’t want to chase long-shot gambles; you want to focus on opportunities with low risk as well as high reward.
That means that there are thousands of stocks on Wall Street that shouldn’t even be on your radar until you get more sophisticated. Period.
Here are three important but simple ways to tell immediately if a stock is even worth looking into, or whether it’s a company you should flat-out ignore:
Major U.S. exchange: A company must trade on the NYSE or Nasdaq to be worth your time. These stock exchanges have higher standards and thus build in a level of protection for investors. That means no “pink sheet” or OTC stocks, and certainly not investments on foreign stock exchanges.
Daily volume of more than 500,000 shares: “Volume” is the number of shares bought and sold in a given day. If a stock doesn’t have high volume, share prices can be very volatile. It’s supply and demand, plain and simple. Consider this: If there are 10 widgets for sale and 100 buyers, sellers can just sit back and wait for the highest possible price. Conversely, if there’s 100 widgets for sale and 10 buyers, it’s a race to the bottom as sellers lowball each other with discounts. The same is true for stocks. Too many traders on one side, and the pricing gets out of whack — which greatly increases your risk level. A higher-volume stock has a much higher likelihood that there are enough buyers and sellers that things balance out, rather than one side holding the other hostage to manipulate pricing.
Market capitalization of more than $500 million: Market capitalization or “market cap” is what the company is worth, at least on Wall Street. This metric is calculated by multiplying a company’s shares outstanding times its stock price. Why is the magic number $500 million? Well, because it’s a good way to avoid smaller and more volatile companies. As with volume, the larger the value of a publicly traded company, the more stability it has. Gigantic companies can fail, too, as we learned with the bankruptcy of General Motors (NYSE:GM) in 2009 — but generally speaking, they can withstand hits better than smaller peers.
All three of these items can be checked in 5 seconds with a visit to quote pages on either Yahoo! Finance or Google Finance.
Of course, there is wiggle room here. You might find a great stock with slightly lower volume or a lower market cap than my guidelines — and that’s not necessarily an instant veto. Conversely, some investors who are very averse to risk might want to stay well above these volume and market cap thresholds.
Investing is never one-size-fits-all, and I encourage you to set your own rules once you’re comfortable doing so. But if you’re just getting started, these tips are a good place to start to limit your risk right out of the gate
Check out a complete list of Investing 101 articles by Jeff Reeves for more on learning how to invest and pick stocks.
Don’t want to keep clicking to read the whole series? Then download the complete series of Jeff’s educational articles for just 99 cents via his e-book “The Frugal Investor’s Guide to Finding Great Stocks: 11 Free Resources to Help Beginners Identify Fantastic Investments.”
You can also buy a printed copy of “The Frugal Investor’s Guide” for $15.10 via online publisher Lulu.