I was researching some general rules and guidelines for buying stocks. Many of the articles I read used terms such as “do your homework” and “risk tolerance”. I found this advice incredibly vague and unhelpful so I decided to create four questions that I believe are important to ask yourself before you purchase a stock.

Question 1: Is this a Trade or Investment?

First, I’ll try to explain the difference between the two in an example. Let’s say you think Google (GOOG) will beat quarterly earnings and the stock will rise higher. You buy the stock a week before earnings are announced to hold for a quick gain. Once the earnings are announced, GOOG is up 18% and you sell the stock to lock in the gains. This is an example of a trade. However, let’s say you love Google and you think in 10 years it going to be up 1500%. In this case you buy some Google stock and just sit on it. Even if they announce horrible earnings and the stock falls, if you still like then keep it. In fact you may be willing to buy more Google as you think it might be a good deal. This is an example of an investment. A trade is short term in nature while an investment is typically where you hold the stock for a longer time frame.

When a trade is not working out for you, you should sell the stock. On the other hand when an investment loses money, it might be wise to add money to the investment to lower your cost basis. A trade is singular in the sense that it does not depend on other stocks you may own. An investment however needs to be looked at in the terms of a portfolio diversification. If you have a portfolio of 25% Google, then adding 25% of Yahoo would not be wise as 50% of your portfolio is invested in search engine stocks. In general, the more diversified portfolio, the better the portfolio.

One word of warning on diversification, if you had a “well diversified portfolio of stocks” during 2008, you would have seen the whole portfolio dramatically lose value. In fact, bonds and real estate also went down in value in 2008 (although bonds did recover quicker than stocks, real estate has yet to recover). Therefore diversification is one tool to lowers risk but it isn’t perfect.

In summary, figure out what type of purchase are you making: a trade or an investment?

Question 2: How much are you willing to lose?

If you can’t sleep at night with your money in the stock market, you shouldn’t be in the market at all. Perhaps you are willing to ride a stock down 15% but you don’t want to lose one penny more than that. It might be a good idea to look at using a trailing stop of 15%. Please realize when you do a trailing stop, if the stock does drop 15%, your stock will get sold. Immediately after that the stock can, and many times will, go back up after you sold. That is the nature of stop losses and to combat that I stop watching the stock after I sold it. There is no point in creating mental anguish when you can’t profit from it. Understanding how much pain you can take is vital. I don’t like the term “risk tolerance” because I know how people work; when the stock market is going up, they are risk tolerant (accepting of risk) and when the stock market goes down, they are risk averse (risk avoiding). Ask yourself how much money are you willing to lose and stick to that amount when the time comes.

Question 3: Does the company you are buying for an investment actually provide intangible value to its customers?

This is pretty easy and doesn’t need much explaining. The company’s stock you are buying needs to provide a value with an intangible component. An example of this is Apple’s Ipod. Why do Apple’s Ipods sell more and at a higher price than a generic MP3 player? It simple, the Ipod is cool and the others aren’t. If the company does provide an intangible component with its product or service, then it’s good investment. If it doesn’t then get ready for thin profit margins, many competitors and most likely a falling stock price. This question is not so critical when dealing with a short term trade only because of the much narrower time frame.

Question 4: Do you believe in the markets/companies you invest in?

The reason I don’t care about “homework” as some call it, is because I have no idea what that means. Homework to me is something you do for school, not for investing. I know investment gurus say homework is studying a company’s annual report and competitor’s annual report to figure out who has a competitive advantage. This even means studying PE ratio’s and Return on Equity/Investment figures. Even though my undergraduate degree is in finance and I am getting an MBA, I still have no idea how this can help you. After reading many annual reports for school and my job, I am convinced Annual Reports are part propaganda and part C.Y.A. (cover your ass-ets) - Nothing More! On top of that, if these annual reports and “homework” work so well, then the hot shot stock analysts working at the big investment houses should be able to pinpoint some of red flags and help us out right? Remember Enron, World Com, etc.?

So my final question is do you believe in the markets you invest in? If you buy an American company, do you believe in the America as a whole - economically and politically? Do you know and believe in what the company does? My favorite example is McDonalds. It’s American company and sells hamburgers. Pretty simple, no credit default swaps here. If you invest overseas, make sure you understand the government you are dealing with.

This analysis may seem very simplistic but anything beyond this is either historical data or speculation. Both are not very helpful. Using McDonald’s as an example, the return on equity for 2008 was 30%. That’s great but how does that help us in 2009 and 2010? Really it only shows that management didn’t get in their own way for 2008. Now let’s say you hear a rumor McDonald’s is coming out with a new type of hamburger? Sounds great but do you really know if this is even true and if it is true, will the new burger work? Plus if you are betting on this hamburger to make you money even if the rumor is false, then this is a trade and not an investment. Historical data and speculation can get you in trouble but if you understand the markets and companies you are investing or even trading, you will have a better time at making money with your stock purchases.

Please note: there is no recommendation to buy or sell here and ModernMoneyBlog.com will not be held responsible for any action on your part. This is for informational purposes only.