HOW DO INVESTORS CHOOSE STOCKS?

By | November 10, 2020

On the New York Stock Exchange alone, billions of stocks are traded every day. However, there are more than 43,000 companies whose stocks can be traded on global stock exchanges. How should investors decide which stocks to buy? To answer this question, we must first understand what stocks are and what kind of returns individuals and institutions hope to obtain through investment. Shares are part of the ownership of a company. 

By buying stocks, investors invest part of the company’s success – or part of its failure – depending on the company’s profits. The price of a stock depends on the number of buyers and sellers in the stock transaction; if there are more people buying than selling, the stock price will increase, and vice versa. The market price of the stock represents the buyer’s and seller’s opinion of the stock and the company’s value. 

Therefore, the stock price may change drastically depending on whether investors believe the company has great potential to increase profitability, even if the company is not yet profitable. Investors usually buy stocks that increase in value over time for profit. Some investors only pursue profits in a short period of time, thus avoiding inflation and reducing profits. Other investors have the goal of “beating the market”, which is to let their funds grow faster than the cumulative earnings performance of all company stocks. 

This idea of ​​”beating the market” has aroused many investors’ arguments – in fact, based on this idea, investors can be roughly divided into two groups. Active investors believe that it is possible to defeat the market by choosing specific stocks and trading timing, while passive investors believe that the market is almost impossible to defeat and will not deliberately choose certain stocks for investment. The term “beat the market” usually refers to obtaining a return on an investment that exceeds the S&P 500 Index (S&P500). 

The S&P 500 is a measure of the average performance of the 500 largest companies in the United States. It is weighted by company valuations. That is to say, companies with higher market value have a greater impact on the S&P index to reiterate, the market value reflects the value of the company recognized by investors, not the actual profit of the company. S&P does not directly reflect the entire market-the prices of many small, medium, and small stocks that fluctuate with different trends. Even so, S&P 500 is still an effective indicator for evaluating the overall market. People often say, “In the short run, the stock market is like a voting machine, but in the long run, it is more like a weighing machine.” 

This means that short-term market fluctuations reflect the public’s opinion, but in the long run, They can often truly reflect the company’s profitability. The goal of active investors is to benefit from the short-term market “voting machine” principle. They believe that the overall response of the market is relatively slow: the stock price will overestimate the value of some companies and underestimate others within a certain period of time, or fail to effectively reflect development trends that can have an impact on the market. 

Active investors hope to take advantage of the lag effect of the market to buy stocks that are too low. In order to identify undervalued stocks, they will investigate the company’s business operations, analyze its financial reports, observe price trends, or use computer algorithms. On the contrary, passive investors pin their hopes on the market situation under the long-term, “weighing machine” model. 

They believe that although the stock market will show information lag at a specific point in time, this lag will be offset over time-if the stocks bought can reflect the general trend of the entire market, over time, It will add value. This process is usually achieved through an “index fund”, which is a collection of stocks that represents a broader market. The S&P 500 is just one of many indexes. All index funds have a common goal: to hold stocks for a long time and ignore short-term market fluctuations. In this way, active investment and passive investment are not incompatible-different investment strategies have their own principles. For example, passive investment usually recommends active stock selection but long-term holding. Investment is by no means a precise scientific discipline: if there is a foolproof investment method, everyone will flock to it.

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