Why You Should Invest and How to Do It

There's a time for short-term trading and a time for investing

Why and how to invest in the stock market
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My career in trading began on the floor of a day trading firm. For many years I believed that short-term trading was superior to investing. With day trading there are no overnight gaps to worry about, fundamentals are irrelevant and risk can be very precisely controlled. Day trading has certain limits though, which is why everyone, including day traders, should also invest in the stock market. Some reasons why are discussed below.

Having done both, investing and short-term trading, one isn't necessarily easier than the other--both require a plan. Here are the basic steps for finding stocks to invest in; trades will typically last two to five years.

Why Invest in the Stock Market

Investing doesn't provide the immediate gratification or frustration that a short-term trade does, but it has a few distinct advantages over short-term trading.

  • In day trading, if you develop a large account you very quickly get "capped out." There simply isn't enough liquidity in most markets for you to keep increasing your positions size indefinitely. With longer term trading though you can acquire a position over days or weeks. The larger your account gets, eventually you need to consider investing because you simply can't find enough shares/opportunities on very short time frames to utilize all your capital effectively.
  • Investing is passive income. With short-term trading you need to constantly be monitoring positions, closing out trades and opening new ones. Your investments work for you all year, with minimal effort once the trade is underway.
  • Investing acts a savings plan. Investing is fun, and forces you to curb spending. Instead of spending money on frivolous things, money is directed toward your investment accounts instead. 

Consider These Two Norms When Investing

In any endeavor it's best to look at norms instead of outliers. When investing here are two norms to keep in mind:

  • Stocks that performed the worst over the last three years will typically tend out outperform over the next three. Stocks that performed the best over the last three years, will typically tend to under-perform over the next three. See research by DeBondt and Thaler

In other words, stocks don't stay strong or weak forever. If you're investing in solid companies, that have been around a long time, then they typically won't stay high or low for very long. There are always downtrends and uptrends, given a long enough time frame. Ideally you want to buy stocks at lower levels compared to higher levels.

Dividend paying stocks are typically well established companies that can afford to distribute a portion of the profits to shareholders. The dividend acts as money in hand, and helps offset fluctuations in the stock price. Investing in solid dividend stocks is a fine way to establish wealth; investing in risky ventures isn't required. Statistics show that dividend paying stocks--the tortoise as opposed to the hare--wins the race over the long-run.

Picking Investment Stocks

Here is a quick summary of what to look for in an investment stock, keeping in mind the two points discussed above.

Use a stock screener to find stocks that fit the following criteria.

  • Dividend yield over 5%, but payout ratio below 100%.
  • Average volume over 300,000 shares.
  • Priced over $2; no penny stocks.
  • IPO date more than a year ago; preference is given to stocks which have been publicly traded for 10 years or more.
  • P/E greater than zero (shows the company is profitable). Consider looking for stocks with a low P/E, for example, greater than zero but less than five. Also consider looking at stocks where the Forward P/E is lower than the current P/E. This shows earnings are expected to increase, and if they do the stock is a better buy at the current price. 
  • Operating Margin Over 10%.

On many stock screeners the bottom two criteria will filter out REITs and ETFs. If you want to view ETFs and REITs, run a separate screen for those using just the first four criteria.

For stocks, run a screen with all six criteria. 

Screening for stocks based on the filters above will produce a list of possible trade candidates. All are not worthy of investment though.

View charts of the stocks produced by the screener above. The next criteria for investing in a stock is:

  • Only buy stocks at major long-term support area. We want to buy stocks at relatively cheap prices (compared to historical values), not expensive prices. 

Investment trades don't require a stop loss, but you should have a price in mind where you get out if conditions don't improve for the stock. An investment doesn't mean you hold it forever if it doesn't do what you expect. Have low tolerance for stocks that keep dropping.

Also, have an exit plan for how you will exit a profitable trade. Define how and why you will exit. Since we used support to get into the trade, you may consider exiting just below a long-term resistance level. Once you are out of your trade, don't worry about what the stock does after. Take the money and invest in other stocks, going through the same process again, as discussed above.

This brings us to one final guideline:

  • If buying at support, and planning to exit just below resistance, the upside potential should outweigh the downside risk (to $0) by at least 2:1. That means that if you buy at $5, you should be reasonable able to get out of the stock at $15 or higher. In an absolute worst case you lose $5 a share (but since we don't hold losers forever, this is highly unlikely), but based on the historical chart it is quite feasible to make $10/share or more. This is known as the risk/reward ratio.

Final Word on Why to Invest and How

Buy strong dividend paying stocks on the cheap. Stocks can't go higher forever, and beaten down stocks don't typically stay low forever (unless something is seriously wrong). Use the criteria discussed above to find stocks to invest in.

Unfortunately there are no guarantees. A stock may look great based on the factors discussed above, but continue to fall in price. The article above discusses tendencies, which apply to many stocks, but any single stock can defy the tendencies. The above list provides a summary of why to invest in stocks, and a basic screen for finding some stocks which may be priced at a value. I dig much deeper though before making a trade; for every 30 stocks analyzed using this approach, only one or two may be worth investing in. This article provides the starting point for your analysis.