Warren Buffet, one of the greatest investors of our time, said ‘never invest in a business you don’t understand. This is one of the golden rules of investing and the very first of a few gems on how to choose a stock to invest in.

Stock investing can be a great way to increase wealth and hedge against inflation but to succeed, you need to pick the right set of companies to invest in. However, choosing the right option for you can be a daunting task, especially with the variety of options currently in the market. Here are tips to consider when choosing:

1. Never invest in a business you don’t understand: A good way to pick stocks is choosing from companies with easy-to-understand business models that produce everyday services and products that you personally experience. If it’s difficult to understand how the company works, it’s best to let it be.
2. Avoid emotion when choosing investments: Do not invest blindly in stocks because there’s hype around it or because you are afraid of missing out, also do not rush into any buying or selling decisions.
3. Spread your risk by diversifying your portfolio: Diversification is important for your investment strategy. Spread your risk by holding a mix of shares and bonds across a range of industries, companies, and countries. Diversification is necessary because if one particular investment performs poorly, it will not ruin the overall performance of your portfolio, so your risk is reduced.
4. Watch out for value traps: value traps refer to when companies’ figures look undervalued relative to their sector peers and their shares look like a good deal but are suffering financial distress. There’s always the risk that the company looks undervalued because it is doing poorly and has low growth potential. To avoid value traps, always consider a company’s qualitative factors, such as its competitive advantage and management effectiveness.
5. Check insider activity: Management of the company buying shares is a strong indication of confidence. Insiders are always more likely to know what the best valuation for their company truly is. It’s a good step for you to pick stocks where the management team has a strong stake in its future performance.
6. Understand financial ratios: Companies make public financial disclosures which consist of three main documents – the balance sheet, profit-and loss-statement, and the cash flow statement. You can calculate several financial ratios that give insight into how the company is managed, its financial stability, and whether it’s profitable. These fundamental analysis ratios should be compared between different years and between peers in the same industry.

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