How to Choose the Right Stocks to Invest In

Karen Riccio

Disclosures

August 24, 2016

In This Article

A Second Way to Approach It: Technical Analysis

Unlike putting the financials of a company under the microscope, technical analysis involves tracking how many shares of a stock trade over a given time and identifying patterns and trends on a stock's price chart. The tracking of volume and monitoring of moving averages are commonly used tools.

Generally speaking, stocks that experience low volumes of trading are more volatile than those with high volumes. Like a kite that needs a stiff wind to stay airborne and soar, stock prices need higher and higher volume to sustain upward movement. Ideally, an average of at least 500,000 shares should change hands daily. Stocks with volume lower than this may be relatively unknown, have yet to turn a profit, or have experienced some other financial woe that turns away investors. Penny stocks, or those that trade under $5, usually have extremely low volume and pose big risks, so don't get lulled by cheaper price tags. Many analysts warn that if you ever see a stock's price rising on declining volume, it's usually a sign of the last few investors jumping into the stock amid all the hype, buying at the top, and willing to pay top dollar. Most of these investors are likely to get burned. Don't be one of them.

As for moving averages, many investors use the average price of a stock over a given time to determine when to buy or sell. For example, you'd find a 50-day moving average by taking the prices for the first 50 days, calculating the average, and then plotting that average on a chart. Take the next group of 50 days—days 2 through 51—find the average, and plot that number on the chart, too. Then do the same for days 3 through 52, and so on. When connecting all of the averages, you'll come up with a 50-day moving average. The same formula can be used for 100-day periods to get a 100-day moving average and 200-day periods to get a 200-day moving average. You get the idea.

That's how to arrive at the averages manually, but it's much easier to use charts provided by finance.yahoo.com or Morningstar.com. After plugging in a ticker symbol, you can review a performance chart for any stock and then customize that chart to show and/or compare any range of moving averages.

In general, if a stock begins to trade below a short-term moving average, such as a 50-day, it suggests that the momentum has shifted downward; on the contrary, if a stock moves above that mark, its momentum has likely turned upward. The shorter the period of time measured, the shorter the trend. That's why serious investors looking for stocks following long-term trends refer to the 200-day moving average. Trading above that mark suggests stability (a signal to buy); trading below it could indicate a price drop is imminent (a signal to sell).

Another thing to consider, outside of fundamental or technical analysis, is cyclical vs noncyclical trends. Some stocks are significantly affected by the ups and downs of the economy (cyclical), and others are largely immune (noncyclical). Anyone who's building a stock portfolio should keep abreast of how the winds are blowing in the economy.

When the economy is growing, consumers have more discretionary income and spend more on luxury items. In a strong economy, you should consider investing in auto manufacturers, airlines, hotel chains, restaurants, furniture retailers, and higher-priced clothing retailers, like Nordstrom and Coach.

On the contrary, when the economy weakens, consumers spend most of their money on necessities and forego vacations or buying new cars. In this climate, these sectors tend to perform well: beverage companies (alcohol and nonalcohol), tobacco companies, pharmacies, healthcare products and services, and manufacturers of household products.

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