Although the stock market can seem random at times, there is a science behind making good investment decisions. Professional investors look at a few key sets of criteria to determine whether to invest in a stock. By understanding how this process works, you'll be able to make more informed decisions for your own portfolio.
One way to make money in stocks is by investing for value. This means to look for companies that have low share prices relative to what they are earning. A common way to measure this is by looking at a company's price-to-earnings ratio, or P/E. If it is low relative to its competitors' P/E, there is a good chance the stock is underpriced. This often happens because investors overreacted to bad news and sold off too many shares. Value investors buy stock in these underpriced companies in the hopes that they'll return to their normal price level.
Growth investors have a different set of criteria for picking stocks. Instead of looking for companies with good earnings today, they look for companies with good prospects for the future. These growth companies are usually newer and don't have a big market share yet. This gives these stocks a chance for huge gains. Growth investors study long-term industry trends to try to predict the next big breakthrough. They want to get into these investments before others discover them and push up prices.
You can also base your stock decisions on a stock's past price movements. Some investors think that a stock's past movements can influence its future price, usually through momentum. When a stock is growing in value, new investors will want to buy in, keeping the trend going upward. When a stock loses value, that can create a sell-off that further lowers its price. These investors are called chartists because they study a stock's pricing graph instead of looking at its financial statements.
Lastly, investors look at economic factors for their investment decisions. Because the stock market tends to follow the economy as a whole, investors want to know whether the economy is strong or weak. Investors can look at the trends in a country's growth in gross domestic product and its employment numbers to see in which direction the economy is going.
Inflation is also very important for stock investing. When inflation is high, stock prices tend to fall. By studying these economic indicators, investors can decide whether to keep investing in stocks or to move into safer investments.
David Rodeck has been writing professionally since 2011. He specializes in insurance, investment management and retirement planning for various websites. He graduated with a Bachelor of Science in economics from McGill University.