Picking stocks the smart way

Deciding which stocks to buy can be confusing and costly. Our expert maps out an effective strategy for novices.

By Walter Updegrave, Money Magazine senior editor

NEW YORK (Money) -- Question: I contribute to my 401(k) and also have quite a bit invested in mutual funds. I now have $10,000 to invest. I plan to invest $3,000 of it in an index fund and to purchase individual stocks with the rest.

Besides making my money grow, one of my main goals is to learn about buying stocks. Any advice on where a busy mom with a full-time job can go to learn about investing in stocks without getting overwhelmed? - Victoria Martinez

Answer: Normally I'm wary of encouraging people to invest in individual stocks. I know that Mad Money's Jim Cramer makes it seem cool and easy. But the fact is, it's tough to do better picking stocks on your own than you could by just putting your money into an index fund or ETF that follows a broad stock market index like the S&P 500. (An ETF is essentially an index fund that trades on an exchange.)

Indeed, over the long term, the majority of professional money managers don't beat the S&P 500 or other appropriate benchmark. And there's even considerable debate as to whether hedge fund managers outperform after taking risk and their blimpish fees into account.

That said, you seem to be going about this in a reasonable way.

I like that you've already got money socked away in mutual funds and in your 401(k), which, presumably, is also invested in mutual funds or other type of managed investment.

So it's not as if your entire financial future depends on the success of your stock-picking prowess. I think this is a good model for others eager to try their hand at buying stocks.

I also like that you want to learn about investing in individual issues rather than tuning into cable investing shows and then firing away buy and sell orders to your broker.

The more you make this stock-investing venture part of an overall strategy and not just a hunt for big gains in stocks, the less likely you'll run into problems later.

Educate yourself

An excellent place to begin the learning process is with two Money 101 lessons: the Basics of Investing and Investing In Stocks. Both are easy to read and cover everything from how the stock market works to how to evaluate different types of stocks to how to pick a broker. These two lessons will give you a good foundation.

After you've read those, steep yourself in the latest news about what's going on in the market and with specific companies and stocks.

I particularly recommend you check out my MONEY colleague Michael Sivy's column, Sivy on Stocks, where you'll find intelligent takes on the economy, the markets and specific stocks.

While you're there, take a look at the Sivy Seventy, which is a listing of the 70 stocks Michael believes are the strongest, most secure and most dominant in their industries. For a more in-depth look at stocks in the news, visit our Stock Spotlight section.

Finally, if you really want to take it up a notch, read "The Intelligent Investor," the classic book on stock investing by legendary value investor Benjamin Graham (aka, the man who taught Warren Buffett much of what he knows). By the way, the most recent edition of "The Intelligent Investor" contains insightful commentary and updated information from Jason Zweig, another colleague of mine at MONEY.

If you do all this, you should have more than enough information to get you on your way to becoming a more informed stock picker.

Stay grounded

But one of the most important skills to develop is the art of forming realistic expectations. If you go into this stock-picking project with the idea that you're going to become some sort of Łberinvestor a la Peter Lynch, you could end up sitting on losses instead of gains.

So my advice is to ease into it. Put just a little money in a couple of stocks initially and then wait at least a few months. If things seem to be going along okay, you can begin to invest more.

But always avoid the urge to engage in rapid trading. Many people - not surprisingly, given how stocks are covered in the financial media - get the sense that being a stock investor means you must stand ready to buy and sell stocks on every tidbit of news. Well, research shows that that's a good approach only if you want to see transaction costs and bad timing eat away at your profits.

To build long-term wealth, take a steadier approach that leaves more of the stock market's gain potential in your pocket, not your broker's.

Finally, think in terms of your overall portfolio not individual stocks. The stocks you buy should fill some specific niche or need within your holdings. If you've got index funds that own large-cap stocks, then maybe you want to focus on smaller companies (recognizing, of course, that smaller issues carry more risk).

Or perhaps you want to concentrate on finding good dividend-paying issues. Or if you have special insights into a particular sector of the economy or a certain industry, then maybe you'll look for superior stocks in that area.

The important thing, though, is that the individual issues you buy complement the other investments you own so that you've got a portfolio that makes sense. If you take that approach, you'll improve the odds that your individual stocks will enhance the performance of your portfolio, rather than drag it down.

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