This article is an excerpt from the Shortform book guide to "A Random Walk Down Wall Street" by Burton G. Malkiel. Shortform has the world's best summaries and analyses of books you should be reading.
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Do you want to know how to decide what stocks to buy? What are three crucial strategies you should know about?
One of the most difficult decisions an investor has to make is how to decide what stocks to buy. But, with approximately 2,800 companies listed on the New York Stock Exchange, where does one start? Economist Burton Malkiel recommends three strategies for picking stocks: The “autopilot” strategy, the “interested-and-engaged” strategy, and the “trust-the-experts” strategy.
Find out how to decide what stocks to buy below.
How to Decide What Stocks to Buy
Once you’ve determined the ideal asset allocation for your age, economic situation, and risk tolerance, the next step is working out how to decide what stocks to buy.
Below, you’ll find Burton Malkie’s three strategies for picking stocks: The “autopilot” strategy, the “interested-and-engaged” strategy, and the “trust-the-experts” strategy.
Understanding these strategies will help you work out how to decide what stocks to buy:
The Autopilot Strategy
The first strategy for picking stocks is the autopilot strategy. This approach consists of purchasing broad index mutual funds or exchange-traded index funds (ETFs) rather than individual stocks or industries.
The autopilot strategy is Malkiel’s preferred method of investing. No matter how knowledgeable or engaged the investor, Malkiel advises building the core of a portfolio around index funds and only making active bets with excess cash.
While the S&P 500 index funds are generally the most popular type of index fund, Malkiel actually recommends that investors choose a total market index fund over an S&P 500 fund. This is because the S&P 500 index excludes smaller stocks that, historically and on average, have outperformed larger ones. Try to find a fund indexed to the Russell 3000, the Wilshire Total Market Index, the CRSP Index, or the MSCI US Broad Market Index.
Of course, diversification is the key to a successful portfolio. But one need not abandon index funds to diversify: There are funds that track REIT, corporate bonds, international capital, and emerging market indices.
The Interested-and-Engaged Strategy
Holding a diverse portfolio of index funds is a low-maintenance and moderate-risk strategy ideal for large sums like your retirement savings. That said, some investors—for example, those with a taste for gambling—will find indexing an entire portfolio boring and may want to try their luck picking winners.
Malkiel advises that thrillseekers only speculate with secondary monies that they can afford to lose, and that they follow four key principles.
Principle #1: Only buy stocks whose earnings growth promises to be above average for at least five years
Simply put, earnings growth is what produces winners. Not only do consistently above-average earnings boost dividends, they also result in higher P/E multiples. That means higher capital gains on top of dividends.
Principle #2: Never overpay for a stock without a firm foundation of value
Expensive stocks with bloated P/E multiples can burn you twice over if earnings don’t materialize (because both dividends and capital gains will decrease).
What you want are reasonably priced stocks with positive growth prospects. Although determining the precise value of a stock is effectively impossible, you can tell whether a stock is reasonably priced by comparing its P/E multiple to that of the market as a whole. If a stock’s P/E is well beyond the market’s, you might be wise to stay away. If the P/E is comparable to the market’s and there’s the promise of growth, that’s a better bet.
(Note that it’s OK to buy stocks with P/E multiples greater than market’s as long as growth prospects are above-average as well.)
Principle #3: Keep an eye out for castles in the air, and take advantage
If you come across a firm-foundation stock around which buzz might build—for example, because the company is about to hire a charismatic CEO or debut a new technology—those are stocks worth purchasing. The key is to buy in before the builders of castles of air drive the price up.
Principle #4: Trade as little as possible
With the advent of commission-free brokerage products, the expenses of trading have been considerably diminished. Nevertheless, you should hold your purchases as long as possible, and, if you have to trade, sell your losers before your winners.
This is because selling your losers reduces your tax burden. Before the end of a calendar year, Malkiel will sell off most of the stocks on which he’s seen a loss to lower his tax bill. There are special cases in which it makes sense to hold a loser—for example, when the company has solid growth prospects—but, in general, you stand to gain by offloading at a loss.
The “Trust-the-Experts” Strategy
Some investors might prefer to entrust their money to a professional. But Malkiel’s years of studying actively managed mutual funds have yielded two key insights: One, that fund managers’ past performance has little bearing on future performance, and two, actively managed funds rarely beat the average market return for long.
Exercise: How to Decide What Stocks to Buy
Explore what the autopilot strategy, the interested-and-engaged strategy, and the trust-the-experts strategy mean for you. Then, work out how to decide what stocks to buy.
- Are you a set-it-and-forget-it type, or do you like to tinker? Which do you think is the best investment strategy for you and why?
- What are the four main asset classes? If you already own a portfolio, are all four represented in your portfolio? Why is it important to have some of all four in your portfolio at all times?
- Imagine you hold 20 shares of Delta, and at the end of the calendar year you see that the stock price has gone down. What might you do to practice tax-loss harvesting?
- If you’re thinking about engaging an investment advisor, what kinds of questions might you ask of him or her?
In this article, you’ve learned about Burton Malkiel’s three strategies for picking stocks. Understanding how to decide what stocks to buy will help you make better decisions, depending on your personal circumstances.
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