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

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. 

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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.