One of the first questions that we ask our broker when our trading account is active is “What shares to buy”. Most investors are natural buyers of stock. The broker is not just a platform to execute the transactions (that is the case with discount brokers). The larger role of a stock broker is also to advise the clients on the right path to take. But as an investor a large part of the onus also lies on you. After all, it is your hard earned money and hence you should be doubly careful when taking any decisions with your money. Here are 6 questions you must ask your broker before buying the shares of any company.
- What is the risk reward in this stock
The most important part of a stock investment decision, is the risk reward ratio. It is the ratio of the probability of loss to the probability of making profits. What should be the ideal ratio? Ideally for trading, the ratio can be 2.5:1 and for investments it must at least by 5:1. Otherwise your position does not make economic sense. For example a risk-reward ratio of 5:1 means that to earn Rs.50, you need to take a risk of Rs.10. That is a fair risk to take. Quite often enthusiastic traders get into a stock with a negative risk-reward ratio. That way can never create wealth because your capital will not ever be sufficient to cover your overall risk on the investment. Get clarity from your broker on this front.
- Do I need to put a stop loss and where to book profits
When it comes to trading positions, there is no question. In fact, you must not even enter into a trading position without a clear stop loss and profit target. Ideally, this stop loss and profit targets must be defined at the time of the order after confirming with your broker. But, what should your strategy be in case of investments? Here it is on a case-to-case basis. Have stop losses in case of volatile stocks. Also ensure to put a stop loss mentally after check with your broker.
- What is the profitability scenario of the company
There are quite a few things you need to understand about a company before investing in a stock but the most important is profitability. Footfalls and eyeballs are great but you must refer a company that is making genuine sales and genuine profits. Check with your broker on whether the company has a profitable business model and whether it is likely to sustain profits. Ask probing questions about the company’s operating profits and the way it manages its interest coverage.
- Is the company have a large capital base
When we talk of a large capital base, we refer to equity and debt. High levels of debt are strictly avoided and this is one of the key questions you need to ask. Be clear not to put money in companies with a large debt or equity base. Too much debt creates financial risk for the business and too much equity leads to dilution of EPS. Both are value depleting. Check with your broker how the company plans to sustain high capital levels and whether the profit growth can justify the same.
- Is there any disruptive about the industry and how is the company prepared
This is a very important point you need to check with your stock broker. Normally, your stock broker will have an in-house research team that can take a view on such issues. Today a lot of industries are vulnerable to disruption and they include sectors like transportation, hospitality, retailing, banking, insurance etc. In such cases, you need to be very clear on how the company plans to handle the disruption and how they plan to disrupt the industry in a big way. A classic example is the way Reliance Jio disrupted the telecom and data business in a big way.
- Does it really fit into my financial plan
This is the last, but perhaps, the most important question. What you are finding out here is whether any purchase you do is in sync with your overall financial plan. Your financial plan is your journey towards your long term financial goals. Any investment has to necessarily fit into your overall financial plan. You can either get the plan prepared separately or you can use the algo provided by your broker to maintain the plan. You need to ask if the purchase is skewing your exposure to equities or is skewing your exposure to a particular theme or industry. Also, your exposure needs to be measured via direct equity and indirect mutual funds. Check with your broker if this investment fits into your overall plan.
These are some of the basic questions you need to ask your broker before buying a stock. Remember, you are entitled to get as much clarity from the broker as possible. For more information visit Angel Broking website.