Investing for Beginners: The 1 Thing You Must Do Before You Buy Stocks

By Markets Fool.com

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You've done the hard work: You have an emergency stash set aside, your high-interest debt is all paid off, and you've found some additional savings from your paycheck. Now it's time to start investing. But where should you put that hard-earned cash?

There's no one-size-fits-all answer to that question. But there is one crucial practice that can set you up for a successful career as an investor: See how well you understand that companies you're investing in.

Nobel Prize-winning physicist Richard Feynman understood that there was a key difference between knowing the name of something, and truly understanding it. In fact, he developed a simple technique to test yourself (thanks to Farnam Street Blog for bringing this to my attention).

Investing for beginners: the four-step process

  1. Choose a concept (in this case, it's why you're investing in a company)
  2. Teach it to a toddler
  3. Identify gaps and go back to source material
  4. Review and simplify

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As a former middle school teacher myself, I fervently believe that the best way to understand something is to try and teach it. If you can limit your explanation to no more than three sentences, and eliminate all the jargon, then you really have command.

Image source: Author.

Naturally, my toddler wasn't the most captive audience. But even the process of doing this helped me identify gaps that I had. After going through this process a number of times (and offering the appropriate rewards to my daughter for sitting still), here's what I have. I hope it can serve as a template for your own investing journey. After reading about the process for the first time, I went into my own portfolio, picked out my seven largest positions (they account for 71% of all of my holdings), and tried to write down why I invested in them. Then I tried explaining it all to my three-year old daughter, seen here.

Amazon: 20.7% of my portfolio

Amazon wants to be the easiest company to use in the world. It will go into any industry where it thinks it can do a better job. Other companies would have to lose money for years (decades?) to challenge Amazon's customer service.

Alphabet: 12.4% of my portfolio

Google makes the world's information easy to search; it has also begun to organize our lives (Maps, Calendar, Gmail, etc.). In return, the company can collect lots of information and sell it to advertisers. Also, it's trying to do crazy-cool stuff to help make the world a better place to live with its Other Bets segment.

Facebook: 11.6% of my portfolio

The world gathers on Facebook -- or Instagram, or WhatsApp -- to share their lives with others. Because of this, Facebook gets lots of data to sell to advertisers. It would be hard to displace Facebook, because you'd have to convince the whole world that there was a better place to gather.

Baidu: 11.6% of my portfolio

Alphabet decided that it wouldn't do business in China, so Baidu is the big search engine there. China is big -- very big. Baidu is basically following Alphabet's blueprint.

Starbucks: 6.6% of my portfolio

People spend time at work, and at home, but many want a third place to gather -- that's what Starbucks is. Because it has so many locations, comfortable settings, access to the internet, and the addictive drug of caffeine, it is very popular in just about every community.

Priceline.com: 4.5% of my portfolio

In most of the world, if you want to find a place to stay while you are away from home, you go to Booking.com -- which is owned by Priceline. Customers know they can find rooms there, and hotel owners know they can find customers there. Priceline gets a little money from every transaction. Airbnb might become a threat sometime soon.

IPG Photonics: 4.1% of my portfolio

Lasers are important because they cut things that we use: big stuff like metal for cars, and small stuff like computer chips. IPG has the strongest and cheapest lasers available because it's the only company that makes all of the parts of their lasers.

If any one of these statements ever changes, then it'd be easy to spot a red flag and consider selling these stocks.

Can you explain why you've invested in the stocks in your portfolio? If not, then follow the four-step process above and see how it works with your investing.

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Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool's board of directors. Brian Stoffel owns shares of Alphabet (A shares), Alphabet (C shares), Amazon.com, Baidu, Facebook, IPG Photonics, Priceline Group, and Starbucks. The Motley Fool owns shares of and recommends Alphabet (A shares), Alphabet (C shares), Amazon.com, Baidu, Facebook, IPG Photonics, Priceline Group, and Starbucks. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.