Ask YOUNG MONEY: How Do I Pick a Stock?
Dear YOUNG MONEY,
My name is Cathy and I'm a university student. I was wondering if you can help me with a project that I have to do for one of my classes.
The teacher has asked us to select five stocks using an online screening program and then justify our selection criteria. I’m not really sure how to do that and on what to base my criteria selection. Would small-cap, growth stocks be better than large-cap value stocks for a 1 year term investment?
I hope you can help me cause I'm really stuck. Thank you!
Cathy
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Dear Cathy,
The answer to your question depends on how much risk you are willing to tolerate. If your assignment is to pick five stocks to hold for one year without regard to risk, then the quality of the instruction is questionable because the relationship between risk and return is at the heart of understanding investments.
Since risk essentially is the possibility of a negative outcome, if you are going to assume a higher risk, then you logically expect the investment to make this risk worthwhile. To do this, the investment should offer a higher potential return. This leads to the general rule that in investing, risk and return are intertwined. If you are offered a high potential return, you should expect the investment to have a correspondingly high risk.
Generally, stocks are riskier than bonds and short-term investments (such as money market funds, certificates of deposit and Treasury bills) and small caps are the riskiest category of stocks (when grouping according to market capitalization, i.e., large caps, mid caps and small caps). On the other hand, stocks have historically provided the highest returns -- over the long term. Within the categories of stocks, small caps provide the highest returns -- again, over the long term. A long-term investment is considered to last more than one year.
Having said all that, diversification into different types of stocks will reduce risk. Whether you hold stocks for one year or 20 and whether you own five stocks or 100, you should diversify your stock portfolio by owning several different types of stocks. As you probably know, you should not put all your eggs in one basket by investing all your money in one security or one group of stocks, such as small caps. If your assignment permits you to hold only five stocks for a year, spread your risk by choosing stocks from large caps, mid caps and small caps.
If you prefer, there are other ways to diversify your stock holdings, such as by industry group (Basic Industry, Capital Goods, Consumer Durables, Consumer Services, Energy, Financial, Transportation, Utilities, Miscellaneous), market behavior (cyclical stocks tied most closely to the overall health of the economy or specific industry vs. defensive stocks of companies making staple goods such as food and beverages) or investment objective (growth stocks vs. income stocks; generally growth stocks are more volatile and income stocks provide steadier income but less opportunity for significant appreciation).
Best wishes with your class assignment.
Carl Surran
Carl Surran is the managing editor for Military Money magazine, a financial education resource for military families. For more information, visit www.militarymoney.com.
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