Apprenticed Investor: Six Keys to Stock Selection

So far, Apprenticed Investor has dealt with a lot of theory. We've discussed how emotions lead to bad decision making, and why you should stick to your plan. But I know what you really want: some advice on how to select stocks. That's our goal today.

The idea is not to pick stocks for you, but to help you develop a methodology for selecting stocks -- a set of tools, a checklist of sorts, to help determine whether a given stock is worthy of your attention.

One caveat: We are not addressing whether you should be a buyer of stocks today. Our discussion assumes your asset allocation is appropriate, and that the market is not in a high-risk, low-return territory. I'll address each of those concerns in a future column.

So without further ado, here's our favorite prepurchase checklist.

How's the Chart?

Charts are a great time saver, and for that reason it's where we begin. You don't have to be a technician to uncover potential problem stocks quickly and eliminate them from contention.

Glimpsing at a chart provides three ways to erase a stock from your list: One, if it's been in a long downtrend, avoid it all costs; two, if it's been flatlining for years; and, three, if it's too volatile for your risk tolerance.

Note, however, that eliminating a given stock doesn't mean forgetting about it. Take, for example, the stock in a downtrend. Since we don't know when the institutional money (i.e., mutual funds) will be done selling, it's simply wiser to wait for them to finish distributing. You can use a 10-day moving average to let you know when the downtrend may be ending.

The same thinking applies to a flat-liner. Instead of guessing what's going to make it finally break out, apply the same moving average to let yourself know when the stock is finally moving.

Meanwhile, stick to charts that don't have problems. (For more detail on how to use technical analysis, check out "Tracking Elephants," parts one and two.)

How's the Sector?

Here's something few people are aware of: Academic studies show the sector a stock is in is actually more important to its performance than the company itself.