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3 Good Reasons to Buy a Stock

May 26, 2017
Investing, Investing Strategy, Investments, Personal Finance, Retirement Planning
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For new investors drawn to the $3.4 billion initial public offering of Snap Inc., the parent company of social media darling Snapchat, watching the stock price the past three months has been a roller coaster. The day after its IPO, Snap sold for more than $27 per share, but it has since traded as low as $18.05.

For more experienced investors, the price fluctuations may bring to mind another big IPO: Facebook. Five years ago this month, Facebook went public with shares snapped up at $38.23 — and a little over three months later the price sank to $18.06. The price of Facebook stock took another year to climb above its initial stock price and now trades near $150.

» Learn more: What is an IPO?

It’s too early to know if Snap stock, now trading around $20, will follow Facebook’s arc. And this points to the difficulty in picking individual stocks and why NerdWallet generally recommends reserving just 10% of your portfolio for them. For most investors, a balanced portfolio is built on exchange-traded funds (ETFs) and mutual funds, which pool individual company stocks, as well as bond funds that allow investors to reap market gains while hedging against inevitable losses.

Even within your portfolio’s stock allocation, it’s helpful to have a framework for knowing whether and when to buy. Here are three good reasons to say yes.

You’re focused on long-term value, not market noise

New investors may see news reports of hot stocks and feel like they are missing out — and maybe they are. Over time, stocks generally return as much as 7% per year after inflation, based on S&P 500 historical averages. But investing is not a get rich quick scheme. In general, if you’re putting money into stocks, you shouldn’t plan on needing to sell for at least five years (original Facebook investors are sure glad they held that long).

Remember, as a shareholder you become a co-owner of the company. As storied investor Warren Buffett once said, “Buy into a company because you want to own it, not because you want the stock to go up.”

Once you buy, check the stock price only on a quarterly, semiannually or annual basis — or buy a lot of antacid medicine to stomach the daily stock-ticker fluctuations.

How do you determine the company’s long-term value? That requires some homework.

The company has strong financial health and outlook

To understand the current and potential value of a company, your appetite for risk must be complemented by a strong taste for research. Understanding company management, competitors and the market are a must, as well as knowing your “price to earnings ratio” from your “earnings per share.” Scratching your head? This guide on stock research will get you started.

At the most basic level, you profit from stocks in two ways: First, of course, is selling at a higher price than you paid — that old maxim, “buy low, sell high.” But many stocks also pay quarterly dividends, a share of the profits, which can give investors a steady return despite fluctuating stock prices. Dividends are often paid by more established companies with strong cash flows — startups and fast-growing companies typically plow all profits back into the company.

» MORE: How to buy stocks

The price is right (for you)

Before buying individual stocks, make sure you’ve already done the following financial health basics: topped off your 401(k) contribution to equal any employer match; created an emergency fund equal to at least three months’ worth of expenses; and paid off high-interest debt like credit card balances. Next, budget for how much you want to spend on individual stocks (again, keeping in mind the recommended allocation of 10% of your portfolio).

Timing when to buy a stock is as tricky as knowing when to sell — and unless you possess a crystal ball, it can be a fool’s errand. Instead, create a long-term strategy to build retirement savings with regular, scheduled contributions to your brokerage accounts. Otherwise, you’re more likely to follow the herd and dump investments when the market hits the skids, or hold back from investing altogether, either of which can be costly.

Investors who bought and held Facebook are glad they did, even if they missed the true bottom at $18.06. Will Snap stockholders who bought near $18.05 feel the same way? Only time will tell.

Kevin Voigt is a staff writer at NerdWallet, a personal finance website. Email: [email protected]. Twitter: @kevinvoigt.