Whenever I find a company I want to invest in, I always make sure to ask myself these four questions before I put money into the stock. All four of these questions should give you a resounding "Yes" answer, and if they do not, you should do more research and rethink your investment strategy. While these questions may be basic, they are crucial to ask yourself so you minimize your financial risk in the long-term future.
1. Do you know what the company does and how it makes money?
The first rule of investing is to invest in what you know. If you don’t know what the company does or how they make money, don’t invest in it. For example, would you invest in an obscure company like Jinpan International Limited (JST), which makes cast resin transformers in China? No, you would not because there are plenty of other wonderful companies like Starbucks, or McDonalds, or Coca-Cola, and you know exactly how they make money now and how they will continue to make money in the future. And if you’re not informed, you’re deformed.
2. Do you know how it will make money in the long-term future?
Because business is constantly changing, you need to be sure that the company’s products and services will be relevant in the future. Technology stocks and retail stocks, for this reason are somewhat riskier. I’m not saying you should not put your money there! But just understand that a companies like Starbucks, McDonalds, or Coca-Cola don’t have to change much to stay relevant, whereas Michael Khors could be a fad that may not continue for 20-30 years. If you’re in it for the long haul, this point is relevant.
Once again, if you don’t know how the company is going to make money in the future, you probably should not be investing in it. Make sure to do your homework and see how their revenue is generated and see how they continue to plan to make in the future. Business is constantly changing and you want to know that the company is keeping up with the rest of the industry or even staying ahead of the curve.
3. Are you willing to hold this stock for at least 3 years?
This is a very important point! Peter Lynch once said, “You get recessions, you have stock market declines. If you don't understand that's going to happen, then you're not ready, you won't do well in the markets". So, if you’re not prepared for that fact and are not willing to hold it for AT LEAST three years, go look for another stock that you ARE willing to hold for that long. If not, you’re probably speculating about the short-term prospects, and you’re more likely to get burned in the short-term future.
4. Are you mentally and financially prepared if the stock market does decline or hits a recession?
The stock market may decline, or it may even hit a recession, and you need to be mentally prepared for that fact. The whole market may drop 20%, and if you can’t face that fact without waiting for it to (hopefully) recover, you should not be investing. Moreover, you should not be investing funds that you will need in the next 3-5 years. For example, if you have any credit card debt or student debt, you should pay that first and THEN invest your extra, unneeded funds in the stock market.
Hope that these questions helped you out. If you have any other questions that you should ask yourself before investing, please put a comment. I’d love to hear about it!