If you’re reading this, you may have decided that you’re going to jump in and buy individual stocks for your investment portfolio. You might be opening a brokerage account to purchase equities independently, or you may have decided to go through an investment advisor.

You have thousands of options to put your money to work for you, so before leaping in, here are four crucial questions to ask yourself or your investment advisor:

What does the company do?

I stand by this cardinal rule: Don’t buy what you don’t understand. When considering purchasing a company’s stock, first understand how the company makes money and what its earnings depend on. Who are the customers buying its product? How’s the economic environment it operates in? What are the trends that support its ability to grow its profits? Who are its competitors in the industry and how are they doing comparatively?

A company that is publicly traded (i.e. has stocks available to the public) will publish annual reports on its website that has most of this information, along with its financials and outlook. Some research online will also help you gain understanding. Your advisor should certainly be able to answer these questions, especially if they are recommending it as an investment.

How risky is the stock?

With this one, you need to compare your risk tolerance against the overall risk expectation of the company stock based on its type by entitlement, market capitalisation, income potential and economic sensitivity.

For example, if you are looking for stability and income in a stock, you will not want to invest in a small cap “start-up” type company that is typically considered riskier.

Remember, a stock will have more risk associated with it if its price movements tend to be volatile and its growth outlook is more unpredictable.

What is the stock’s valuation?

Along with deciding “what to buy”, at “what price to buy” is just as important, yet often overlooked. If you learn anything in this article, learn this important point because it will serve you well in the long-run.

There’s a big difference between a “good company” and a “good stock investment”.

 

Let me explain: The end game is to buy a stock at a lower price than what you sell it for in the future so you can make a profit. Obviously the lower the purchase price and higher the selling price, the greater your return. There are several very well run companies out there that you may be interested in. However, due to a lot of interest or “hype”, investors may have poured money into its stock – driving up its price significantly more than what the true value of the company is.

Buying at this time may result in you “overpaying” for its shares, only to see it normalise and fall down the road. Or the upside is limited, hurting your ability to earn a decent profit.

There are analysts who make calculations to suggest what the stock’s price should be. You’ll sometimes hear of terms like Price-to-Earnings (or P/E) or Price-to-Book Value (P/BV). While it’s not a perfect gauge, it will give you an indication of whether you should buy a company’s shares now, wait for the stock to go on “sale”, or look at a similar competitor that may offer more upside or match your risk tolerance.

These type of data are often available online with commentary. If you are looking at options with your investment advisor, make sure he/she discusses the valuation with you. There are professional analysts who study companies and write reports on their view of its shares. Your advisor should be able to review this with you and provide a copy. If they are not willing to do these things, find another advisor!

What, if any are the tax implications?

Depending on which country or territory you live in, you’ll be subject to different taxes on various types of income. In some cases you will be taxed on capital gains (profit you make when you sell the stock), and this may or may not be at a different rate than if you were to receive dividends. In some cases, you may not be taxed at all.

It’s prudent to be aware of these implications so you’re not caught off guard when you have to pay your tax bill. It can also give you an opportunity to structure your investments in such a way to minimise taxes. A financial or tax advisor can help you with this.

Conclusion:

Investing in stocks doesn’t come without risks but I firmly believe that exposure to equities can provide you with returns you won’t necessarily get with other classes. Buying individual stocks is one method. If you’re looking to start small and want the benefit of diversification, look at stock mutual funds or exchange-traded funds (ETFs).

Bottom line: Have a mindset of holding equities for mid-to-longer term, incorporate them as part of a diversified portfolio, do some homework and ask the right questions.

Want to learn more about stocks? You may also like Why Stocks Are Often Ignored but Vital for Your Portfolio.