How do the stock market legends do it?
You know, those well-known names like Warren Buffett, Seth Klarman and Peter Lynch?
They make millions – billions – of dollars by picking the right stocks again and again.
What stock picking strategies do they use?
What do they know that we don’t, and how do they know where to start looking?
After all, there are hundreds and hundreds of stocks to choose from. The global stock universe is absolutely huge and can be very confusing.
As a beginner, dreaming of making your money work for you, where do you even begin?
There’s a lot of risks out there.
Do you ever ask yourself questions such as What is the best stock picking strategy? or How do I successfully pick stocks?
If so, this post is for you.
How to pick stocks
for dummies for the perpetually confused
Fortunately, there are very few stock investment strategies for beginners which makes how to choose investments much easier.
According to Investopedia, Warren Buffett’s first rule is simply “…never lose money”.
“Never forget rule number one.”
There you have it. From the master himself.
I know it sounds facetious, but actually, it’s one of the best stock picking tips. It’s simple and it’s effective.
If you find yourself confused about how to choose shares, always remember that the main way of losing money in the stock market is by taking big risks and not protecting yourself from any losses that may occur.
It’s far from a stupid strategy.
Protecting yourself from losing money was one of three elements of investing, taught by Buffett’s mentor, Benjamin Graham. (The other two are at the bottom of this post.)
This is advice that Buffett sensibly took to heart, and that has made him billions of dollars over the years.
But, how do you know when you’re taking big risks with your money when you don’t know the first thing about choosing stocks?
The answer is to understand when you’re speculating and not investing. (To help with this, I’ve produced a cheat sheet of good financial ratios to look for in a firm’s accounts. It’s one of the many free downloads in the resource library. Get the password by filling in the form at the bottom of this page.)
But, it can take a lot of personal discipline and experience to reach this point.
The easy way for beginners to protect themselves against losing money is to simply avoid the following overhyped – and speculative – strategies.
Hot stock picking strategies to avoid (unless you have a crystal ball)
All of the following stock picking strategies are speculative in nature.
This means, that unless you are able to see into the future, you’re gambling that stock prices will go up (or down). You’re effectively banking on someone else paying more for your stock than you’re prepared to pay for yourself. After all, why else would you be selling it?
Every single one of the stock picking strategies that follow goes against Buffett’s two rules. That should tell you something.
Moreover, they’re all a form of technical analysis, beloved by short-term traders but not by long-term stock pickers.
This is the analysis that uses price and volume data to make stock-picking decisions.
I suspect you’ve seen all those line graphs and candlestick charts representing market movements plastered all over the evening news? These represent types of technical analysis.
It’s strictly not a strategy in itself, but rather a collection of stock picking strategies using analytics used by traders to assess when best to buy or sell a stock. It relies on the supply and demand of securities to determine prices which are then plotted onto the charts in one form or another.
The idea of this analysis is to find patterns in the charts and determine when your security is going to go up or down in price, and trade accordingly. It’s a way of trying to time the market.
Technical analysis doesn’t help with choosing stocks to buy for the long term. (Only fundamental analysis can help you with this.) It merely tries to predict the best times to buy and sell, information that is irrelevant to an investor but is oxygen to a speculator.
If you find yourself looking at these charts and considering any of the following “hot” stock picking strategies…you’re likely speculating, and not investing.
Stock selection strategies for intraday trading
Day trading is buying and selling a security – a stock in this case – during the same day. Intraday trading is buying a security to hold for a short time, such as a few days, and then selling.
The ideas that follow are different short term trading strategies, all of which are speculative.
Swing trading involves using mainly technical analysis to predict intermediate-term price movements to make money.
It’s a short-sighted strategy and often misses longer-term patterns, but more importantly to a true investor, it’s risky.
What happens in global markets when your exchange is closed for the weekend will affect your stock’s price. For long-term investors, this is irrelevant.
The candlestick charts tell us the high and low price points of a stock, and also the prices when the market opened and closed. The charts look very impressive on the evening news.
Once again, the idea is to look for familiar patterns. However, it should be used in combination with other technical analysis to get make the best use of it. So, unless you’re committed to spending a good deal of time learning this, to then trade with a high risk of losing your money, I recommend not bothering.
Looking for patterns on candlestick graphs, like other forms of technical analysis, is looking for the best trading times and should not be confused with investing.
Personally, I prefer the candlestick patterns made by my scented candle on my windowsill. (The odds of me picking a long-term winning stock by staring at them are likely very similar.)
3.Dividend Capture Strategy
Another day trading strategy. This one involves buying dividend stocks before the ex-dividend date then selling them on.
The ex-dividend date of a share is the day on which it starts to trade without the former dividend value. In other words, it’s the first day of a firm’s new dividend policy.
The idea is you sell after the ex-dividend date because the stock is likely to drop in price by the dividend amount. This is because the new shareholders are not entitled to the dividend. ( The share price is often artificially inflated prior to the ex-dividend date in any case as demand for the share increases).
In theory, the amount of dividend received by the trader should be more than the amount the stock drops by giving you a small profit.
Given that every trade costs you money, this is highly risky for a retail investor with limited cash for trading.
The dividend capture strategy should not be confused with the more traditional, and far more sensible, dividend stock strategy for income.
The latter involves buying and holding stable dividend stocks to earn passive income over time. The former strategy involves frequent buying and selling of shares over a short timescale in the hope the price goes up, you cash in on the dividend, then the price drops down. Quite literally.
If you think you can beat the supercomputers owned by large brokers looking for these ex-dividend dates and trading accordingly, then good luck to you.
My relatively slow human brain is no match!
4. Stock market cycles
Apparently, there are recurring cycles of varying frequencies in financial markets that can be used to predict future movements in security prices.
Most of them, to be fair, do have logical explanations.
But, they’re very loose.
See what you think of these stock picking strategies.
Kondratieff Wave (K-wave)
Russian economist Nikolai Kondratieff theorised that Western economies have 54-year cycles related to the economy and commodity prices.
His observations were made in the 1920s by tracing cycles from the 1780s onwards. Interestingly, the US depression of the 1930s fitted into this cycle.
However, Joesph Stalin apparently didn’t think much of the idea as poor Kondratieff was executed in 1938. However, since then other work has come to light to give the theory more credence.
British and Dutch economists spotted similar cycles of 50-52 years and 50-60 years in length respectively.
So, find out where we are on the K-wave and plan your trading accordingly.
Personally, I like something more concrete. After all, just because something has happened in the past, doesn’t guarantee the same in the future. I also see patterns in many sets of data if I stare at them for long enough.
This is usually connected with real estate markets, but interestingly, 3 x 18 = 54.
Again, find where the firm is on the cycle and buy and sell its stock to fit the pattern.
This one amuses me because I can’t find any rational explanation in it whatsoever.
The decennial pattern is the pattern of average stock market returns on the Dow Jones Industrial Average (DJIA) index.
And the pattern is broken down by the last digit in the year.
Apparently, years ending in 0 have the worst returns, and those that end in a 5 have the best!
Now, it’s true that the DJIA was up every year ending in 5 from 1885 to 1995. However, 2005 was an exception – it dropped by 0.6%.
There are always exceptions to every rule…
Now this one, to be fair, does have a more rational explanation.
See what you think.
This cycle connects the DJIA index to US presidential election years.
The years are put into groups according to whether they were election years, or first, second and third years afterwards.
Apparently, the third year (the year prior to an election) historically shows the best returns with the DJIA experiencing positive returns in every pre-election year from 1943 to 2007.
The alleged reason for the cycle is politicians injecting stimulus into the economy because they want to get elected.
However, stock markets have shown less consistency with this theory (unsurprisingly).
In my view there are two big problems with all these wave strategies.
The first is there’s not much data to use to evidence the theories. 59 US elections and 4 completed K-waves is not much to go on, statistically speaking.
And secondly, they don’t help us choose stocks! They only attempt to show us when to buy and sell and what could happen in financial markets in the future.
5. Elliott Wave Theory
Former account R.N. Elliott theorised that stock markets trade in respective patterns, and are not the random chaos they appear to be.
He proposed that swings in investor psychology show up in patterns in financial markets. The patterns are repetitive and may be used to predict price movements in stocks.
But, interestingly, Elliott practitioners disagree with this as an application, although they will use the theory to help with this anlaysis.
It takes a lot of time to become proficient in this technique which is not great for a retail investor.
It’s also quite complex but if you want to read more about it, Investopedia has a good article on it.
However, again if you look at large quantities of data long enough, I suspect you can find many patterns in it.
But, unless the causes of the patterns are also the causes of outperforming stocks, there’s no way we can predict future returns.
6. Intermarket Analysis
This strategy works on the principle that all financial markets are interrelated and influence each other.
The idea is to conduct an analysis of major securities categories, such as stock and bonds, and find trends and any possible changes in these trends.
A change in one market can be a signal for changes in other markets. In theory, this should help with buy/sell decisions.
You can also use it, along with technical analysis of the business cycle, to find trends in sectors of stock markets. This should help with identifying promising stocks.
For example, at the beginning of an economic cycle, many industrial sectors such as utilities, financial services and transport stocks do fairly well. Once the economy starts to grow, retailers, manufacturers and health care industries also start to expand. Later on, they’re joined by commodities and technology stocks.
However, this doesn’t always hold true depending on the wider context of the cycle.
For example, the nature of the response to the coronavirus pandemic with its associated recession meant that healthcare firms generally did well but transportation sectors suffered. This is the opposite of what you’d expect in a ‘normal’ recession (whatever that is).
And this highlights the problem with most cycles – you need the contextual understanding to make head or tail of them.
Unlike the next strategy.
7. The Foolish Four
In the 1990s there was a stock-picking technique going by this name. I mention it again here because we like to reinvent the wheel and it may be in vogue again at some point.
So, just in case…
Apparently, you can spend only 15 minutes a year on your investments and you could make a killing with minimal risk.
The idea is you select five stocks with the lowest stock prices and the highest dividends. You drop the one with the lowest price.
Then, put 40% of your money into the one with the second-lowest price and 20% in each of the three remaining shares.
Repeat each year until your make money.
Does it sound too good to be true?
For example, in the year 2000 and using the DJIA as the index, the index dropped by 4.7%.
The Foolish four stocks?
Fell by 14%.
8. Doing what works by beating the market
Many fund managers claim to be able to beat the market.
They also like to claim that we can all do it too by investing in their funds.
James O’Shaughnessy did such a thing n the 1990s.
He reckoned that by buying a basket of 50 stocks with the highest one-year annual returns, share prices less than 1.5x revenues, and with five straight years of rising earnings, an investor could average a double-figure return on their money.
The strategy seemed to work really well, at the beginning.
Then, he publicised it. And…
Two of his funds were closed down and stock markets crushed every other one of his funds for almost four years running.
What used to work won’t always continue to work. Although many people do believe that if they beat the market over any short period of time, something is working as it should.
But to grow your wealth, you need to be right in the long-run too.
9. January Effect
This strategy tells us that buying lots of small stocks around mid-December and holding them into mid-January before selling will net you some good returns.
By small stocks, I’m referring to the shares of small and medium sized enterprises (SMEs), not bigger corporate entities.
The idea is based on the propensity of these small stocks to produce big gains at the beginning of the year.
Sounds like easy money?
Hmmmm. Many investors sell their worst-performing stocks near the end of the year to lock in any losses. These losses can be offset against tax, so it’s appealing to do this.
This means that many of the stocks being sold off are because people don’t want them because they’re not making money. A possible red flag.
Consequently, fund managers often don’t want to buy stocks that don’t perform because it may damage their fund’s performance over the year.
Smaller stocks can often be harder to shift than larger more liquid stocks from big well-known companies. So, it’s often difficult to find buyers…
Unless the buyer thinks they’re going to make money…
10. CAN SLIM/high growth stocks
CANSLIM is an acronym for a trading method where each letter stands for a factor to look for in a high-growth stock. (For example C is current quarterly earnings per share, A is annual earnings increases over the last five years… You get the gist.)
By high-growth, I’m referring to a share price that is growing faster than the average one.
The idea behind this method is to find these stocks before institutional investors, such as fund managers, get hold of them.
Once these big-budget investors snap them up, the price will soar.
Or, so the logic goes.
Firstly, good luck with finding a growth stock before a professional investor.
The flip side.
These stocks can’t be held onto for long because their value is in the potential growth. And growth is not indefinite. And then?
What goes up must come down.
And they usually do. With a big crash.
11.Using an app for stock picking strategies
Although not strictly a stock picking strategy in itself, trading apps, like eToro and capital.com, are all the rage now.
They make buying and selling stocks really easy.
And therein, lies the danger. You can trade anywhere at any time, reacting to market information as it’s provided.
You can make easy money by buying black (prices going up) and selling red (price dropping).
The reality is that each time we trade, we pay our brokers to do so – our brokers make money. So, for brokerages, it makes sense to try and persuade us to buy and sell as often as possible.
In addition, the continual ticker tapes and market prices all over news programmes and the internet mean we’re constantly surrounded by stock data.
But the information provided about company fundamentals, such as strategy and financial position?
The trouble with this approach is company share prices become removed from the very real firm that issued the stock.
To trade, we don’t need to understand company fundamentals. We only need to watch the price movements of its stock.
To quote Oscar Wilde, “A cynic is a man who knows the price of everything, and the value of nothing.”
And the stock market is one of the biggest cynics there is.
A friend of mine, a very experienced former senior analyst at one of the big banks, once told me that company valuations were more an art than a science.
And analyst stock price targets drive market movements.
Stock picking strategies that work
So, with all the above strategies to avoid for the beginner investor, how do you pick a long term stock?
The answer to this is to be sound in the basics of the company fundamentals before buying or selling a stock .
What do I mean by this?
Getting an understanding of the company accounts and its strategy.
This information is easily found in annual reports, and usually online under investor relations tabs, or similar on company websites.
Fundamentals are figures such as profitability, revenue, assets and liabilities. Many investors use certain stock picking ratios of these numbers for the initial screening of the stock universe. (To see the ones recommended by Benjamin Graham in his book, The Intelligent Investor, download the free pdf from the resource library on this site. Get the password by filling in the form at the bottom of this page.)
This is what I do. And, once I’ve chosen a group of firms to focus on, I begin to understand the company by checking out its financial results more fully, examining debt and other liabilities and analysing at its strategy in its markets.
Be under no illusion. This is a lot of work when done properly! And it involves understanding the accounts of big corporations.
This is why professional analysts spend a lot of time researching companies and getting to know their management psychology.
However, for those beginning to invest without knowledge of company accounts, where do you start?
There is a way.
Successful stock picking strategies for beginners
Yes, I’m serious.
Unless you want to spend your time to spend learning to read accounts and analysing markets, don’t try. (However, these are brilliant skills to learn and will help you with your own business no end. But, I digress.)
I think one of the best ways to get started investing is to buy into a passive fund that tracks an index in a developed market, indices such as the FTSE 100 or the S&P 500.
The idea behind a passive tracker fund is to deliver you a return on your investment in line with the market. If the index goes up, so does your return. If it goes down, well, so does your return. A good fund will mirror the movements of the index it’s tracking
Moreover, according to ig.com, the FTSE 100 has produced an average 7.75% return since its inception in 1984. Not bad.
And the best bit?
Because you effectively have a small stake in every single company listed on that index, your lower your risk of losing money by diversifying your investment.
This is actionable key element of Buffett’s advice, ‘don’t lose money’.
Investing in passive funds also fits two of the three investing criteria of Benjamin Graham when picking stocks for the long-term:
- Protect yourself against losses
- Aspire to adequate, not extraordinary performance
The third criterion?
But, when you effectively own every stock in an index, I think we can loosen up on this one a little. Keep it simple.
2.Understand the difference between speculation and investment
Confusing speculation with investment is a mistake made by many investors, myself included.
But, if you can get to grips with it, it could help you heed Buffett’s advice to not lose money. (Reading my post 11 Reasons Why Investing Is Different From Risky Speculating will also help with this.)
I look at it this way. Speculation is putting your money into a so-called investment when you have no idea what’s going to happen to it – you hope for the best. Just like roulette. Investing is when you are confident that over time you’ll not lose your money. And you’re hopeful you’ll make some.
Every single one of the stock picking strategies to avoid in this blog post is a speculative ‘investment’. In other words, they’re all gambles.
And, to be fair, there’s nothing wrong with gambling provided you understand that’s what you’re doing. This is why it’s sensible to avoid these stock-picking strategies when you’re beginning to invest. It’s risk management 101.
If you do decide to try one, treat your purchases like you’re going to a casino for a night out, and you’ll not go far wrong! Just don’t take them seriously.
In my view, investing is following Graham’s three criteria. It works for me, and it works even better for Billionaire Buffett!
All these speculative mechanical strategies may provide positive returns in the short-term. But, over time these gains will fade.
Man-made rules always have exceptions, and patterns appear in data when stared at for too long.
Moreover, if a formula works in the beginning, once it’s no longer secret, it’ll stop working as the investing herd follows the same psychology. Then, it pays to be different.
So, ignore the dumb stock picking strategies, learn the difference between investing and speculating, find a good ETF, and always remember Warren Buffett’s answer to this question:
What is the best hot stock picking strategy?
Don’t lose money.
If you do want to try and narrow down a range of stocks to choose from, download the free pdf of Ben Graham’s ratios to apply to a stock universe from the resource library. (Get the password to the library by filling in the form below.)
Give the ratios a try with a virtual portfolio and see how you get on. It’s a lot of fun!
Have you tried any of the speculative strategies mentioned in this post? How did you do? Would you do it again?
FREE DOWNLOADABLE CHEATSHEET OF BENJAMIN GRAHAM INSPIRED FINANCIAL RATIOS FOR SUCCESSFUL STOCK PICKING
Get the password for the library containing the cheatsheet by filling out this form:
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