US debt crisis casts shadow over markets

Investing in stocks and shares can be a risky business but our experts offer an eight-point guide to success.

Turmoil in the stock markets is expected to hit any time as the debt crisis enveloping the United States looks set to hit shares across the world. Investors will be waiting nervously to hear whether the Obama administration and Congress finally agrees the US budget before next Tuesday's deadline. The current uncertainty demonstrates that investing in shares is neither easy nor for the faint-hearted. While it's possible to make handsome profits, you can easily lose your life savings if there's an unexpected sharp slump.

Even specialist fund managers who have followed global stock markets for many years find it a challenge, so for the relative novice it can be a nightmare. What should they invest in? How do they know if a company is any good? Whose advice can they trust?

We have quizzed a string of fund managers, economists, stockbrokers, independent financial advisers and stock market commentators to draw up an eight-point guide to the techniques and secrets known by the most successful professional investors.

1. Know your goals

Don't just pick stocks at random. Be clear what you're trying to achieve and decide on your attitude to risk because no investment is completely safe. The broadest definition of risk is the impact that losing your entire investment would have on your life, so make your decisions accordingly.

You may be willing to speculate in the hope of tripling your initial investment over the next few months through buying into relatively unknown companies that can soar in value. Alternatively, you may prefer to only invest in global giants that can be relied upon to deliver steady returns.

2. Develop an investment style

The very best fund managers each take a distinct approach which they stick with regardless of what's happening – and that is the key to delivering decent longer-term returns, according to David Kuo, director of website Motley Fool.

"If you're not prepared to spend time developing a particular style and understanding how it works then your best course of action is following the market by investing in an index tracker," he insists.

There are a number of styles to follow but three of the most common are dividend investing, value investing and growth investing – and they will appeal to different personalities.

Dividend investors, for example, are slightly more cautious as they are only interested in receiving a regular income from their investments. Value investors, on the other hand, look for companies that have fallen in value but which they believe have the capacity to recover strongly. Growth investors, meanwhile, try to find companies with the capability of growing faster than the market expects.

"Jumping from one investment style to another might be quite fun in the early days when you're trying to find your feet," adds Mr Kuo. "If you are planning to do that then one of the better ways is to use a fantasy portfolio where you can test your style without committing real money."

3. Remove the emotion

You need to look at your investments coldly and not allow emotions to cloud your judgment, according to Peter Day, a partner in Killik & Co. A golden rule in this respect is running your winners and cutting your losers. "When things are going well for a company they tend to continue for various reasons, such as being able to attract good staff because people want to be associated with them," he says. "Similarly, when it starts to go wrong for a company it also continues and you're usually better off getting out early rather than waiting and hoping it may eventually recover."

4. Embrace diversification

It is vital to be diversified because when things turn sour for a company they normally do so in a big way – and there are plenty of examples. You only have to consider the experience of oil giant BP, which was badly damaged by last year's Gulf of Mexico disaster, points out Mr Day.

"If you only hold four or five shares and one of them goes wrong it can make a very big dent in the value of your overall portfolio," he says. "That's why we always encourage clients to hold at least 15 stocks."

Diversification is important on a stock and sector level, according to Alec Letchfield, manager of the HSBC UK Focus fund. "You should try to create a portfolio of companies with differing characteristics so you won't be as vulnerable if you're wrong about an issue. There needs to be a blend of assets with a variety of drivers."

For example, it would be dangerous to pack your portfolio with stocks that all relied on consumers spending money – such as food retailers and hotels – as you're likely to suffer badly should the economy and stock market take a turn for the worse.

5. Understand macro-economics

It's never been more important to consider how economic issues around the world can potentially impact upon investments, according to Stuart Thomson, chief economist at Ignis Asset Management.

When people are worried about inflation and potentially losing their jobs, for example, this is likely to impact upon their willingness to spend. While some sectors still do well in difficult times – such as utilities because people still need electricity – those involved in "luxury" areas are likely to suffer.

"What used to be a stock picker's universe has become much more dominated by macro-economic trends because we've gone from a long period of strong growth to a much more volatile environment in which growth is likely to remain below trend for some time," he says.

Two particular leading indicators are vital, he suggests. The first are those analysing business sentiment – such as purchasing managers' indices, which are produced from surveys of conditions and what is happening at an individual company level.

The second are studies which reveal how closely expectations resemble the reality. "These are the surprise indicators and look at whether the data has been better or worse than consensus over recent periods," explains Mr Thomson.

6. Stick to what you know

When you're just starting out it's best to stick with what you know. For example, if you have particular knowledge of a company or sector then it's worth putting that to use before exploring other avenues, because you effectively have an inside track.

For any potential investment you need to first read the statements from the chairman and chief executive in the most recently published annual report before deciding where to put your money, according to Mr Kuo.

"Once you've read both carefully you need to ask yourself whether you can summarise what that company does in one sentence," he says. "If you can't then you shouldn't invest in it because you need to have a good understanding of that business if you are going to be a part owner."

Only by having a thorough grasp of what its management is trying to achieve will you be able to assess a company and make sense of the balance sheet. There may very well be a viable reason why it has taken on so much debt, for example, which is why you must consider all the evidence.

7. Scrutinise the company

According to Patrick Connolly, head of communications at AWD Chase de Vere, investment managers will routinely examine the products or services offered by a company and consider the future demand for these.

"They will also look at the scalability of the company, the strength of its brand and the barriers to entry to stop new competitors, while researching existing competitors will reveal which firms in the sector are in the strongest position and may also evaluate company suppliers or buyers," he says.

The fact is that no private investor will enjoy the same level of access as a successful, established fund manager with millions of pounds to invest. They won't, for example, be able to ring up and ask chief executives a list of questions about their plans.

However, there are plenty of freely-available documents which can help you decide whether or not a company is a viable investment. There are the annual report and accounts, as well as analysis and commentary from stock brokers and websites such as Digital Look and Motley Fool.

8. Analyse the figures – and review

Information contained in balance sheets and profit and loss accounts is historic and this means it may well be out of date. However, it's still worth examining the previous year's data to search for ongoing trends – both positive and negative – which could influence your opinion.

"Managers will look at the financial numbers of the company, including profits, earnings, debt and cash flow," adds Mr Connolly. "They will look in detail at the company's balance sheet and profit and loss statement to find any anomalies or surprises."

Free cash flow – the amount of money a company has actually made after all the various costs have been removed – is particularly important, says Mr Day. "Accountants can hide the real picture of a company in their results but free cash flow is an important statistic because no financial engineering can go into it," he explains.

Private investors often make the mistake of doing all the hard work in choosing viable investments and then leaving them alone – at which point anything can happen. You must review your investments regularly to ensure they continue to meet your needs, keep up to date with the stocks you have chosen and decide if news flow is likely to have an effect on your decisions.