As a beginner into stock investing, you might wonder when an investor decides to buy a stock.
Unfortunately, the answer is different for every investor depending on their approach to investing. Passive investors and technical/fundamental analysts have different rules regarding stock purchases.
In this post, we will demystify the criteria that different investors use to determine when to buy stocks. We will also help you get an idea of when it isn't proper to buy a stock.
Let's dive in!
Reasons to Buy a Stock
The simplest and most common reason for most investors to buy stocks is to contribute to their retirement fund. This is usually observed in retirement accounts like a 401(k) or IRA.
Such investors are usually already invested in index funds or ETFs (Exchange Traded Funds) and plan to keep investing in them periodically for the long term. In other words, the investment vehicle selection has already been made, and buying the underlying stocks is just part of the long-term strategy.
This approach has also been referred to as "dollar-cost averaging". It is also favored by those who want to reduce the impact of volatility on their portfolios. But it's mainly the natural approach of those who don't have a lump sum to invest.
The Fundamentals are Strong
Another reason for buying a stock is that its fundamentals are strong. To know this, however, one needs to apply fundamental analysis.
Fundamental analysis concerns itself with the company's financials, management, and industry. An investor who wishes to determine if a stock is fundamentally healthy will have to access the company's financial statements and use some analysis tools.
This type of analysis includes but is not limited to several factors such as leverage (how much debt a company has relative to its equity), profitability, growth rates, management quality, and product quality.
Macroeconomic factors are sometimes also included in fundamental analysis as long as they are perceived to be affecting the stock value.
The Stock is Trading at a Discount
A common reason for buying is that a stock with an underlying financially healthy business is trading at a discount.
Just as the market usually overvalues a stock, sometimes it also undervalues it. This is a common phenomenon and an opportunity for those who understand the irrationality behind it.
A good example is when bad news about a stock surfaces and the market overreacts by overselling it, driving the price far below its "intrinsic" value (what an investor thinks the business is worth).
The fundamental analyst will want to see if the selling is justified by taking a look at the company's fundamentals and how serious the factor that caused the stock to dip is. If they think that it's unjustified, they will buy the stock.
A Technical Signal Indicates an Opportunity
The last most common reason someone may buy a stock is when a technical signal indicates an opportunity.
Technical analysts use technical signals to help one determine when to buy or sell a stock.
Traders use all kinds of technical signals, but the premise is usually the same: based on the study of past price action, a stock's price is about to move in the opposite direction.
These signals often point to the fact that a stock may be oversold, so there is a chance that its price will soon start going up.
When Not to Buy a Stock
Successful investors don't just know when to buy a stock. They also understand when they shouldn't buy one.
And this is actually an equally great challenge for many stock pickers because it requires something more than investment knowledge: self-awareness and discipline.
So, make sure that you don't buy a stock just because:
- You are fond of something associated with it
- Its price significantly dropped recently (you should always look at the relation between value and price)
- Someone you admire recommended it
- The investment idea makes you feel smart
- The consensus is in favor of it
- It appears to be a rare opportunity
If you keep an eye out on these reasons that often urge an investor to buy a stock, then the better your chances of long-term success will be.
Just ask yourself this question every time you intend to buy a stock: are any of these reasons the motivating force behind my decision to buy?
As you can see, there are various reasons for buying a stock depending on what type of investor you are. Passive investors and technical and fundamental analysts all rely on different criteria to help them decide if they should buy a stock.
But when it comes to knowing when you shouldn't buy, the reasons are more often than not shared.
After reading this guide, you may now have a better understanding of the intricacies behind such decisions. On top of that, we hope that this guide helped you realize what investment approach better suits your temperament and needs.