Found a share you love? Don’t buy until you’ve answered this vital question

If your new favourite stock doesn’t do this, is it really worth owning?

The content of this article was relevant at the time of publishing. Circumstances change continuously and caution should therefore be exercised when relying upon any content contained within this article.

When investing, your capital is at risk. The value of your investments can go down as well as up and you may get back less than you put in.

Read More

The content of this article is provided for information purposes only and is not intended to be, nor does it constitute, any form of personal advice. Investments in a currency other than sterling are exposed to currency exchange risk. Currency exchange rates are constantly changing, which may affect the value of the investment in sterling terms. You could lose money in sterling even if the stock price rises in the currency of origin. Stocks listed on overseas exchanges may be subject to additional dealing and exchange rate charges, and may have other tax implications, and may not provide the same, or any, regulatory protection as in the UK.

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More.

Stock-picking requires time and a willingness to thoroughly research companies before buying them. Even Warren Buffett — generally regarded as the best stock-picker that’s ever lived — believes the vast majority of us shouldn’t be active investors. Those who enjoy the challenge, however, should read on.

The big question

Reading through MoneyWeek executive editor John Stepek’s (highly recommended) new book, The Sceptical Investor, I’m reminded of what I believe is one of the most important questions to ask whenever you’re considering purchasing a new stock.

Regardless of which company we’re talking about (Stepek uses mining giant BHP Group in his example), you need to ask yourself whether it’s going to outperform the benchmark.

While there are no guarantees in investing, if you can’t at least state why you think this is going to happen, you arguably shouldn’t be buying said stock. To answer that question, however, you first need to select an appropriate benchmark.

In his example, Stepek reflects that it can make sense to use the FTSE 100 (BHP is, after all, a constituent of the index) and then ask yourself what it is about BHP that will allow it to outperform the market’s top tier.

A response might be that miners are likely to do well going forward (perhaps due to a commodities bull market) and you don’t want your investment to be impacted by the woes of other companies in unrelated sectors. Since there are plenty of large-caps that aren’t necessarily good investments right now, there’s a logic to that.

But if you think the mining sector will outperform, then a better benchmark would surely be something like an investment trust focused on miners, he suggests.

So now a different question presents itself: Why buy BHP over a fund, particularly as the latter helps to lower risk through diversification?

To be clear, Stepek doesn’t rule out buying BHP but he does stress the importance of matching a bullish call with the “correct financial instrument” — be it in the form of individual shares or something else — if you’re going to make the most money. 

What to do instead…

If, after consideration, you feel your new favourite stock is unlikely to outperform the (most appropriate) benchmark, then it makes sense to look into ways of investing in the benchmark instead.

Since the existence of a specialist fund for particular sectors isn’t a given and the FTSE 100 could still be the best comparison, I’ll stick to focusing on exchange-traded funds here.

As they sound, these are low-cost, passive vehicles that help an investor generate the same return as the market, minus a bit of tracking error and the obligatory fees. The iShares Core FTSE 100 and the Vanguard FTSE 100 UCITS ETF are examples.

Another positive from selecting these funds is that they pay dividends, thus allowing investors to receive income for less risk than if they bought shares in specific companies instead. The funds mentioned above offer yields of 4.24% and 4.73%, respectively — lower than BHP, but still worth having. 

Bottom line? Taking the time to question whether a particular share will truly outperform its benchmark might seem (irritatingly) sensible to some, but those committed to generating the best returns over the long term should acknowledge this is a vital step to take. 

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

Paul Summers has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

More on Investing Articles

Investing Articles

Up 670% in 2 years! This former penny share is skyrocketing on SpaceX contracts

Shares of Filtronic (LON:FTC) were soaring to multi-year highs today after another contract win with SpaceX. Should I buy this…

Read more »

Investing Articles

Why is the Greatland Gold (GGP) share price up 10% today?

Our writer looks at the reasons why the Greatland Gold (GGP) share price is the AIM 100’s best performer today.

Read more »

Passive income text with pin graph chart on business table
Investing Articles

What do I need for a passive income of £100k a year?

How much would I need to invest to collect a very healthy yearly passive income on my retirement? Surprisingly, the…

Read more »

US Stock

£2k invested in Nvidia stock 2 years ago is now worth this boggling amount…

Jon Smith details how much unrealised profit an investor would have from buying Nvidia stock but is cautious about what…

Read more »

Investing Articles

2 value stocks that still look cheap despite the FTSE rally!

Harvey Jones picks out two UK value stocks that still look nicely priced even as the UK index climbs. He…

Read more »

Dividend Shares

I asked ChatGPT to build the perfect passive income portfolio and here’s the result

Jon Smith turns to the world of AI to try and find out whether ChatGPT could build an investor a…

Read more »

Investing Articles

£20,000 to invest? Here’s how the FTSE 100 could deliver a £2,040 passive income

Here are two ways that investors with a lump sum to spend could target a large passive income with FTSE…

Read more »

Runner standing at the starting point with 2025 year for starting in new year 2025 to achieve business planing and success concept.
Investing Articles

Here’s how someone could start investing in 2025 with just £1,000

Planning to start investing in 2025? This writer highlights two very different stocks that might be worth considering for a…

Read more »