Due Diligence

Researching investments before you buy

Understanding how to properly investigate investments before committing capital

Category: Analysis & Research
Difficulty: Beginner

Definition

The process of investigating and analyzing an investment opportunity before making a financial commitment. It involves reviewing financial data, business operations, and potential risks.

Why Due Diligence Matters

Benefits of Proper Research

• Understand the investment thoroughly
• Identify potential risks and red flags
• Make informed decisions based on facts
• Avoid fraudulent or overvalued investments

Consequences of Inadequate Research

• Unexpected losses from unknown risks
• Investment in declining or failing companies
• Emotional decision-making during market stress
• Susceptibility to investment scams

Stock Research Made Simple

Step 1: What Do They Actually Do?

• Can you explain their business to a 10-year-old?
• How do they make money?
• Would you shop there or use their product?

Step 2: Are They Making Money?

• Do they turn a profit every year?
• Are profits going up or down?
• Are they drowning in debt?
• Do they have cash in the bank?

Step 3: Is the Price Crazy?

• Are you paying too much for each dollar of profit?
• How does it compare to similar companies?
• Has the price doubled recently? (Warning sign)

Step 4: What About the Competition?

• Is this industry growing or dying?
• Who are the main rivals?
• Is technology about to kill this business?

Fund Research Even Simpler

Step 1: What’s the Game Plan?

• What do they buy?
• What are they trying to do?
• Does it match what you want?

Step 2: How Have They Done?

• Good performance over 5+ years?
• Better or worse than similar funds?
• Did they crash harder in bad times?

Step 3: What’s It Cost?

• Annual fee under 1%? (Lower is better)
• Any fees to buy or sell?
• Fees eat your profits

Step 4: Who’s Running It?

• Same manager for years?
• Good track record?
• Do they put their own money in it?

Questions That Matter

About the Company

• How do they make money?
• What if competitors beat them?
• Are the bosses smart and honest?
• Is this business growing or shrinking?

About the Price

• Am I paying a fair price?
• What’s the worst that could happen?
• Is this a good time to buy?
• Does this fit my goals?

Where to Get Info

Free Stuff

• Company websites - investor section
• Yahoo Finance or Google Finance
• Company’s annual report
  
• Recent news about the company

What to Read

• Annual report (company’s yearly story)
• Recent news (any big changes?)
• Financial numbers (sales, profits, debts)
• What analysts think (but think for yourself)

Warning Signs

Bad Company Signs

• Sales dropping every year
• Drowning in debt
• CEOs keep quitting
• Confusing financial reports

Scam Warning Signs

• “Guaranteed” high returns
• “Buy now or miss out forever”
• Can’t find basic information
• Too complicated to understand

Simple Checklist

Before You Buy:

• I understand what this is
• I know how it makes money
• I checked the basic numbers
• I know the main risks
  
• The price seems fair
• It matches my goals
• I won’t go broke if this fails

Easy Options (Less Research Needed)

• Index funds: Own everything, low cost
• Target-date funds: Auto-pilot investing
• Blue-chip stocks: Big, boring, stable companies
• Dollar-cost averaging: Same amount every month

Different Approaches

Beginners

• Start simple
• Use index funds
  
• Focus on costs and basic risks
• Don’t overthink it

More Experienced

• Read financial statements
• Compare similar companies
• Think about business cycles
• Study management

No Time?

• Use mutual funds
• Focus on fees and track record
• Consider professional help for big money

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External Resources

• Government Resources: SEC Investor.gov - Official SEC guidance on investment research
• Financial Education: Morningstar Investment Research - Free investment education and research tools

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Related Terms

Research Methods

• Fundamental Analysis - Analyzing company business and financial health
• P/E Ratio - Key metric for valuing stocks
• Value Investing - Investment approach emphasizing thorough research

Risk Management

• Risk Tolerance - Understanding your comfort with investment risk
• Diversification - Reducing risk through variety
• Portfolio Construction - Building balanced investment portfolios

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All investments involve risk of loss, including loss of principal. Past performance does not guarantee future results. This information is for educational purposes only and does not constitute investment advice.