An Introductory Guide to Securities Selection

Fact checked by Kirsten Rohrs SchmittReviewed by Pamela RodriguezFact checked by Kirsten Rohrs SchmittReviewed by Pamela Rodriguez

Selecting suitable securities among stocks, bonds, and other assets can feel to some like being made the coach of a team in a sport you don’t know—and, for some who’ve avoided investing previously, never thought you’d have to play. This comprehensive guide will help you get started as you look to master the game of securities selection. We’ll break down the types of securities, explain the essentials for selecting among your prospects analysis techniques, and show you how to put the best team out on the field.

Securities selection is strategically analyzing and picking investments that align with your financial goals and the amount of risk you’re willing to take. However, with so many options and complex strategies to consider, it’s easy to feel overwhelmed and confused about where to start. Just as a coach carefully evaluates each athlete’s strengths, weaknesses, and how they fit into the overall strategy, you’ll learn how to analyze individual securities and select the ones best suited to help you achieve your investment objectives. And like a well-rounded team, a diversified portfolio can help you manage risk and increase your chances of long-term success.

Luckily, no big game coaches go it alone anymore—they lean on a crowd of sideline and pitching coaches, etc., each expert in some minute part of the sport. Similarly, as you continue investing, other articles across Investopedia can help you when questions and new situations arise; you have an entire staff here at work for you. (We link below to articles on the key things you’ll want to review next.) For now, let’s get you in the game. Whether you’re a rookie investor learning the ropes or a seasoned pro looking to up your play, you’ll find valuable strategies below to help you build and manage a winning portfolio.

Key Takeaways

• Securities selection, done well, is essential for crafting a suitable and long-term winning investment portfolio.
• Fundamental analysis examines financial ratios and metrics to gauge a company’s fiscal stability.
• Technical analysis uses indicators and chart patterns to spot market trends and guide investment choices.
• Quantitative analysis takes statistical data and models to assess securities and shape investment approaches.
• Managing your risk is crucial to selecting securities, as it helps ensure your portfolio’s long-term success.

Key Concepts in Security Selection

Before you can start building your portfolio, it’s essential to understand the basic rules and terminology.

Securities

First, in the investing world, securities are the tradable financial instruments representing ownership in a publicly traded company (stocks or equities) or a creditor relationship with a governmental body or a corporation (bonds). When you buy a security, you’re purchasing a piece of a company or lending money to an organization. The U.S. Securities and Exchange Commission (SEC) regulates their trade.

Things that aren’t securities include real estate, collectibles, cryptocurrencies, insurance products, and commodities. However, to make things a tad more complicated, just as if a company sells insurance or builds collectibles and can sell shares of stock, that is, securities, fund managers now often pool together collections of real estate investments, currencies, and commodities, and can sell you shares in that pool. Those, too, are securities. You can buy securities that are shares in a mutual or exchange-traded fund (ETF). If you’ve seen controversies in the news in recent years over “crypto funds,” it’s because some fund managers wanted to pool what they posit aren’t securities, say, bitcoin tokens, and sell shares in that pool as securities. The SEC has relented, finally allowing them (through futures) in 2021 and directly holding bitcoins in 2024. Those shares are securities; while the bitcoins they hold are not.

Risk and Return

Next, it’s important to understand the concept of risk and return. In general, investments with higher potential returns also have more risk. To use extremes to make the concept clear, if you take $5 and buy a lotto ticket, you’re accepting all-but-total risk (your chances of losing are millions of times more likely than any gains in a multistate game), but the payoff can be the kind that gets people on TV. If you keep the $5 safe where it is, you’re taking on zero risk, but you also have zero chance of profit.

As an investor, you’ll need to determine your risk tolerance and how much uncertainty you will accept in exchange for potentially getting higher returns.

Diversification

This is one of the most important principles to learn when selecting securities. It refers to spreading your investments across different types of securities, industries, and geographic regions. Just as a coach wouldn’t want an entire team of quarterbacks, investors generally shouldn’t put all their money into a single stock or sector. By diversifying your portfolio, you’re mixing things that will react differently to the same events in the market.

For example, bonds typically go up when the stock market is not doing well, and obviously, stocks are the opposite. That’s why, traditionally, people might keep a 60/40 split (60% for stocks, 40% for bonds) in their portfolios to balance the risks of stocks falling with the steadiness of bonds.

The Market

Finally, it’s crucial to understand the role of market forces in securities selection. Investing is influenced by economic conditions, political events, investor sentiment, and the specifics of the companies whose shares you’ve bought. Unfortunately, as in sports, you can line up the best players and still not win. Broader forces are often at work, though diversification will help ensure your team is still competitive no matter what the market is doing. In any sport, you need to adjust to changing conditions by changing strategies or putting different players on the field. You’ll have to do something similar with your securities selection. There’s more than the score to review (that is, whether the value of your portfolio is up or down):

• Economic health: Economic indicators like gross domestic product growth, employment rates, and inflation can help you figure out the risks and prospects for different sectors and their securities.
• Political events and policy changes: Elections, regulatory decisions, and geopolitical tensions can create uncertainty and volatility, affecting the performance of specific sectors or regions.
• Investor sentiment: Market psychology can drive short-term price movements, even if they seem disconnected from underlying fundamentals. Phenomena like “bull markets” and “bear markets” can influence the market’s overall direction. In selecting securities, part of your task will be to respond to, not simply follow, the emotional swings of the market.
• Industry trends: Each sector has specific challenges and prospects from technological advances, regulatory changes, or shifts in consumer behavior. You’ll need to track these.
• Company performance: Individual companies’ financial health, growth prospects, and competitive position significantly affect their stock and corporate bond prices and overall market performance.

Considering so many variables, knowing where to focus your attention and find actionable insights can be challenging. However, there are analytical tools to help you do this. Fundamental, technical and qualitative are three of the most important market analysis models.

Fundamental Analysis

Fundamental analysis is a method used to assess the real (intrinsic) value of a security (or a market) by examining the critical economic and financial factors involved. Common sense might lead you to wonder what else you would review, and we’ll come to that. For now, this approach aims to reveal the true value of a company’s stock or bond, making it easier to identify undervalued or overvalued securities.

When analyzing stocks, you’ll review these central financial ratios to gauge a company’s profitability, financial leverage, and overall financial performance (each can be found on many investment and brokerage platforms):

• Debt-to-equity ratio: This measures a company’s financial leverage (debt) by comparing its total liabilities to its shareholder equity. A high debt-to-equity ratio could indicate a company that’s more risky to invest in: the more it owes, the more it needs to earn (at least potentially) to return dividends or appreciate in value.
• Price-to-book (P/B) ratio: This compares a company’s stock price to its book value (the value of its assets minus its liabilities). A lower P/B ratio suggests a bargain.
• Price-to-earnings (P/E) ratio: This compares a company’s stock price to its earnings per share, helping you decide whether a stock is overvalued or undervalued compared with its peers or the broader market.
• Price-to-sales (P/S) ratio: This compares a company’s stock price to its sales. If it’s low, it could be undervalued.
• Return on equity (ROE): ROE measures how much profit a company generates with the money shareholders have invested. A higher ROE generally indicates a more efficient and profitable firm.

Assessing a company’s financial health and stability also involves analyzing its financial statements, including the balance sheet, income statement, and cash flow statement. By scrutinizing these materials (or reviewing the analyses of those who have), you will know far more about a company’s revenue streams, how it manages its costs and cash flow, and whether it’s efficient with its assets.

While fundamental analysis is most commonly associated with stocks, it can also be applied to bonds. When analyzing bonds, you’ll likely focus on the following:

• Credit rating: Bonds are assigned credit ratings by agencies like Standard & Poor’s and Moody’s, which assess the issuer’s ability to make timely interest payments and repay the principal. Higher-rated bonds are generally considered safer but offer lower yields, while lower-rated bonds offer higher yields but come with greater default risk.
• Interest coverage ratio: This measures a company’s ability to make interest payments on its debt. A higher interest coverage ratio indicates a company that can better meet its debt obligations.
• Debt-to-EBITDA ratio: This compares a company’s debt to its earnings before interest, taxes, depreciation, and amortization (EBITDA). A lower ratio suggests that a company has a more manageable debt burden relative to its earnings.

Government bonds such as U.S. Treasurys are often the first choice for many investors, particularly those newer to the bond market. Treasurys are considered the safest investments because they are backed by the full faith and credit of the U.S. government. When conducting fundamental analysis on government bonds, investors typically focus on interest rates, inflation, and economic growth. While Treasurys generally offer lower yields than corporate bonds (less risk equating to less profit potential as usual), they often provide a stable foundation for a well-diversified portfolio.

By conducting fundamental analysis on stocks and bonds, investors can make more informed decisions when constructing a well-diversified portfolio that aligns with their financial goals and risk tolerance. In the next section, we’ll explore technical analysis, another approach to evaluating securities, which focuses on historical price and volume data to identify trends and patterns.

Technical Analysis

Technical analysis is a method of securities selection that focuses on studying historical market data, notably price and volume, to forecast future price movements. Unlike fundamental analysis, which is premised on the idea that the value of a company comes from something intrinsic to the firm, technical analysis seeks to identify patterns and signals within market data as a better guide to where the value or price of a company comes from. As its name suggests, it gets very technical quickly. That said, it’s good to know what technical analysis can do for you when selecting securities, even if you’re not ready to use your trading platform just yet to look for chart patterns.

Here are some of the most common technical analysis tools:

• Moving averages: These indicators smooth out the data on securities’ prices by creating a constantly updated average price over a specific period. The two most common are the simple moving average (SMA) and the exponential moving average (EMA). Traders often use moving averages to determine the direction in which a trend is moving. They’re also looking for what’s called support and resistance levels: places on the chart that provide a range within which they think the security is most likely to trade. Think of these like the over/under on sports games: when you later see the results, you would be genuinely surprised if the narrow range of expected scores turned out to be a blowout.
• Relative strength index (RSI): This indicates momentum, the magnitude of recent price changes, to see if some security looks to have dipped too far or not enough in the market. RSI values range from 0 to 100. When the RSI is above 70, it often means that the security’s price might have increased too much and could be ready to drop a little. When the RSI is below 30, it suggests that the price might have fallen too much and could be ready to rise again shortly.
• Moving average convergence divergence (MACD): This mouthful of an indicator is also used to track how much momentum a security has, this time by showing the relationship between two moving averages of a security’s price. The MACD line is calculated by subtracting the 26-period EMA from the 12-period EMA. A nine-day EMA of the MACD, called the “signal line,” is then plotted on top of the MACD line, acting as a trigger for buy and sell signals. You don’t need to settle in and start calculating these (not least since many platforms do this work for you), but it’s good to know what it’s used for if any analyst you’re reading mentions it.

In addition to these indicators, technical analysts also look for chart patterns to predict where prices are likely headed:

• Head and shoulders: This pattern resembles a person’s head and shoulders (see below). It has three peaks, with the middle one being the tallest (the head) and the ones on either side being slightly lower (the shoulders). When this pattern shows up, it could mean the price is set to go down.
• Cup and handle: Another that looks just like it sounds: a cup with a handle. The cup is a U-shape, and the handle is a small dip after the cup. This pattern usually shows up when the price has been steady for a while and can be expected to go up.

The use of technical analysis in bond markets is less prevalent than with stocks, given that they have less volatility and their prices move for different reasons than stocks. There’s also less trading for many bond instruments. Despite these limitations, some technical indicators and chart patterns can still be useful when analyzing bonds. For example, support and resistance levels, trend lines, and moving averages can help investors identify potential entry and exit points or confirm trends in bond prices. In addition, technical analysis can be used to assess the overall strength or weakness of a bond market, such as the one for U.S. Treasurys, and help clarify for you how to balance the asset allocation of your portfolio.

Quantitative Analysis for Securities Selection

Quantitative analysis is a tool for selecting investments based on mathematical and statistical models. While this description might make the math-phobic around us wince, the idea behind it is straightforward: using data and computer programs to find investment prospects that would be hard to find otherwise.

This approach thus entails analyzing large amounts of data quickly. By looking at patterns, trends, and anomalies in the data, as in technical analysis, quantitative analysts can decide which investments might be undervalued or have growth potential. Some standard techniques used in quantitative analysis include the following:

• Time series analysis: This examines how an investment’s price has changed over time and tries to predict future changes.
• Regression analysis: This is used to understand the relationship between factors that might affect an investment’s price, such as interest rates or economic growth.
• Monte Carlo simulation: This is a way of testing how a security would do in different scenarios by running many simulations with slightly altered inputs.

Quantitative models often focus on measurable characteristics of investments, such as volatility (how much the price moves up and down), liquidity (how easily it can be bought and sold), and historical prices. However, it’s important to remember that quantitative analysis is just one tool among many. Most successful investors combine at least some facets of quantitative, fundamental, and technical analysis to get a well-rounded view of potential investments.

Combining Fundamental, Technical, and Quantitative Analysis

While each of these methods can be powerful on its own, many investors find that combining them is far more fruitful. By examining a potential investment from these different angles, you can move forward with a comprehensive understanding of a security’s strengths, weaknesses, and overall potential.

Combining the Three Forms of Analysis

For instance, you might start by using fundamental analysis to identify companies with good health and good long-term growth prospects. Then, you could use technical analysis to determine the best time to buy based on recent prices and chart patterns. Finally, quantitative analysis could help you assess the investment’s risk profile and potential returns compared with other securities in your portfolio.

Alternatively, you could use each method as a filter, gradually narrowing down a list of prospects. For example, you could begin with a broad universe of stocks and use quantitative analysis to screen for those that meet specific criteria, like having low volatility or high liquidity. Then, you could apply fundamental analysis to the remaining candidates to find those with the most robust company financials. Finally, technical analysis could help you choose the best times to buy and sell the securities you’ve found through the other two methods.

Of course, combining these methods could give you conflicting signals, and it’s up to you to weigh the evidence and decide based on your goals, risk tolerance, and overall investment strategy. It’s common, too, to put more weight on one method than the others based on your investment style and goals. For example, if you’re a long-term investor focused on value, you might place more emphasis on fundamental analysis. If you’re a short-term trader looking to capitalize on market momentum, technical analysis may be your primary focus.

Ultimately, you’ll want to find a balance that works for you while remaining flexible as the market changes. Remember, investing always involves some level of risk, and no single method or combination can guarantee success. This brings us to our next topic.

Risk Management

Investing is not just about picking the right stocks or bonds. It’s also about managing risk—the chance your investments could lose value. As a coach, you wouldn’t want to send a team onto the field without a game plan and proper equipment; so, too, you shouldn’t invest without a strategy to handle potential setbacks.

Here are the major types of risks:

• Credit risk: The chance that the entity you’ve invested in can’t pay back its debts.
• Liquidity risk: The possibility that you won’t be able to sell your investment quickly or at a fair price when needed.
• Market risk: The chance that the overall market will go down, taking your investments with it.
• Operational risk: The chance that something will go wrong within the company you’ve invested in, like a major scandal or a big mistake.

To protect your investments from these, here’s what should form part of a prudent game plan:

• Diversification: As we’ve covered, instead of investing everything in one stock or bond, spread your money across different types of investments, industries, and even countries.
• Stop-loss orders: This is like setting a safety net under your investments. You can set these on your brokerage platform. They automatically sell an asset if it drops below a specific price. This can help you avoid big losses if the market takes a sudden dive.
• Rebalancing: Over time, some of your investments may grow faster than others, throwing your portfolio off balance. Rebalancing involves buying and selling securities to restore your original mix.

The point of these strategies isn’t to completely avoid risk—it’s about being smart about the risks you take and having a plan to handle them. Then, you’re ready to weather the market’s ups and downs.

In the next section, we’ll look at how to put all these pieces with an example.

Example of a Selection Strategy including an ETF

Let’s take a look at a real-life example of how a value investor (might use these strategies to pick a winning investment. After some research, you are looking to invest in the Vanguard Value ETF (VTV). Now, as a fund, it holds many different securities, and you’re buying a share in the fund and thus all these other securities. In this case, VTV focuses on big (large capitalization) companies that are considered undervalued according to fundamental analysis measures like low P/E, P/B, and P/S ratios.

By investing in VTV, you’re buying a piece of many companies that fit the profile you want, all in one go. The Vanguard Value ETF also lets you see exactly which companies are in the fund so you know where your money is going. When you analyze this ETF’s holdings, you see what a value investor would want: stocks in companies with a higher intrinsic value than market value. The firms are financially sound with steady revenue and earnings growth but are trading at a discount to their historical valuations.

Being methodological like this helps to mitigate risk and capitalize when the market isn’t efficient—like spotting a star player who finished low in the annual draft. Picking stocks this way, based on sound fundamentals and attractive valuations, is a vital part of the value investing playbook. It’s a way to manage risk while leaving room to run up the score. Instead of paying top dollar for flashy stocks that might not have a strong foundation, value investors look for solid companies trading at a discount.

By using VTV to find value stocks for you, you’re tapping into the experience and knowledge of the fund’s managers. Finding ETFs that match your approach to security selection is a great way to begin learning this crucial part of investing.

How Do Economic Events Affect Securities Selection?

They can affect the performance and prospects of individual companies, sectors, and entire markets. For example, a global recession might hurt companies in cyclical industries like travel and luxury goods while boosting defensive sectors (those that remain even-keeled even through downturns) like utilities and healthcare. Similarly, changes in interest rates, currency fluctuations, or geopolitical tensions can create both risks and prospects for investors.

How Often Should an Investor Review Their Securities Selection?

You should periodically review your securities selection to ensure it still aligns with their goals and market conditions. The frequency of these reviews depends on your time horizon, but a thorough review at least once a year is wise. More active investors might check in quarterly or monthly, while long-term investors might be comfortable with the less frequent annual check-ins. Regular reviews allow investors to rebalance their portfolios, cut losses on underperforming assets, and take advantage of new prospects.

How Do Interest Rates Impact Securities Selection?

When interest rates are low, companies can borrow money cheaply to fund growth, and investors are more willing to take risks in search of higher returns. This can favor stocks, especially those in growth-oriented sectors like technology and consumer discretionary. Meanwhile, when rates rise, borrowing becomes more expensive, and investors may shift to safer, income-generating assets like bonds. In this environment, investors might prefer more defensive stocks with stable cash flows and high dividends.

Do Sustainable and Ethical Considerations Play a Part in Securities Selection?

In recent years, sustainable and ethical investing has remained popular as investors seek to align their portfolios with their values. This approach, also known as environmental, social, and governance (ESG) investing, involves selecting securities based on a company’s performance in areas like carbon emissions, labor practices, and boardroom diversity. ESG investors prioritize companies with strong social and environmental track records.

The Bottom Line

Selecting the right securities is crucial for building a strong, resilient investment portfolio that can weather market ups and downs and ultimately help you reach your financial goals. To make informed decisions, investors can rely on a combination of fundamental analysis, which assesses a company’s intrinsic value based on its financial health and growth prospects; technical analysis, which uses historical price and volume data to identify trends and patterns; and quantitative analysis, which employs mathematical and statistical models to process large amounts of data and spot opportunities.

Regular reviews and rebalancing can help keep portfolios on track while managing risk with diversification, and stop-loss orders can help mitigate potential losses. Success requires a strategic game plan, the right tools and techniques, and the flexibility to adapt to a changing market.

Read the original article on Investopedia.