Equity selection process, a complete guide. From stock selection and risk management to trade execution, asset allocation, and portfolio evaluation.

Equity selection consists of multiple stages. Investment analysts and traders go through different stages when selecting stocks for their investment portfolio. In this article, we will dive deep into this process, and by the end of this article, you will be able to select stocks like professional investment analysts and also lower your market risk.

Stage 1 Stock Screening.

This stage is designed to find stocks tailored to your investment strategy. Traders filter stocks based on Beta, market cap, and financial ratios.

• Beta compares your selected stock's risk to the market. In the case of the US stock market, the comparison is made between your stock and the S&P 500. A beta of 2, for example, indicates that your selected stock is twice as volatile as the S&P 500. Beta can also be used to find stocks that have inverse or negative correlation with the market. For example, a Beta of -1 means that your selected stock moves in the opposite direction to the S&P 500.
• Market capitalization can also define a stock's riskiness. For example, larger companies with higher market cap tend to be less volatile, as they attract larger players. Investment banks and brokerage companies have risk management departments that often tell traders to buy only larger cap stocks of well-known companies. That's why when a stock is included in an index, its price skyrockets, as it gets attention from institutional investors.
• Traders can also use financial ratios to find stocks that look better than their closest peers. For example, if a P/E ratio of some stock is 15 and the average ratio among its closest peers is 30, it means that your selected stock is undervalued based on this ratio, as the company's earnings are higher than its closest peers relative to its stock price. But you should not rely only on one ratio; always consider filtering stocks based on multiple ratios, usually 3-4, to have a wider perspective on the company's financial health. You can learn more about financial ratios in my article on how to analyze a company usign financial ratios. Stock selection is done using stock screeners—web-based applications that help you sort stocks based on your criteria. For example, you can use Diversset, a stock screener and efficient investment portfolio builder, or the Financial Modeling Prep stock screener. You can also build your own custom stock screener in Excel using the Financial Modeling Prep Screener API endpoint to filter stocks based on your preferences, such as risk level, volatility, and company size.

Stage 2 Fundamental Analysis.

After filtering stocks, you should have a list of 10-15 top stocks tailored to your risk appetite (risk-averse investors tend to choose less volatile stocks with smaller standard deviations), investment horizon (risk-averse investors choose value stocks for the long term), and age (the younger you are, the more risk you should be willing to take). Once you have a list of stocks, it's time for fundamental analysis. Fundamental analysis consists of

• financial statements analysis, where you undertake horizontal and vertical analysis to spot irregularities and identify a company's financial trends. For horizontal analysis, you can use Financial Modeling Prep API endpoints such as the Income Growth API endpoint, Balance Sheet Growth API endpoint, and Cash Flow Growth API endpoint.
• Another part of financial statements analysis is ratios analysis, where you calculate financial ratios from financial statements to evaluate the company's financial health and compare it to its closest peers to find the best stock. You can calculate ratios manually after reading my quick guide on financial ratios, or you can extract valuable company financial statements from the Financial Modeling Prep Ratios API endpoint.
• Additionally, fundamental analysis includes examining the company in more detail, which involves reading consolidated audited financial reports, including auditors' notes. This helps spot company risks and note irregularities in financial statements. Also, traders should examine the company's website, specifically the Investor Relations section, and review company management notes and other relevant presentations found there. Doing this enables investors and traders to understand management's expectations and company risks and use this data in their financial forecasts.
• The last part of fundamental analysis is equity valuation. Equity valuation is the process of calculating the stock's target price. A target price is the stock price based on forecasted financial statements—in simple terms, it is the company's stock fair value. If the stock's market price is below its target price, it means that the stock is undervalued and has growth potential since its fair value is above its market price. Conversely, if the stock's market price is above its target price, the stock is overvalued as its fair value is below its market price. The stock target price can be calculated using one of three valuation models. The first is the Discounted Cash Flow (DCF) model, where investors discount the company's cash flow, calculate terminal value, and then calculate stock fair value. I've written a detailed guide on stock target price calculation in Excel, or you can also build your stock market app that will extract the stock target price calculated using the DCF model. Another popular valuation model is the Dividend Discount Model (DDM). In this model, you forecast the company's dividends using the Pratt and Gordon model, discount dividend payments, calculate the company's terminal value, and then assign stock fair value. However, not all companies pay dividends, so this model is less popular than DCF among traders and investment analysts. Another useful equity valuation model is the Price-Income or Multipliers model. You examine a company's financial ratios, compare them to its closest peers, calculate coefficients based on your comparison, and then assign a company's target price based on your calculations. This is the simplest model as it requires fewer assumptions, but it can be time-consuming, especially if you collect all the data manually. Fortunately, you don't have to collect data manually, as you can use the Financial Modeling Prep Ratios API endpoint. I've written a detailed guide on how to calculate stock fair value in Google Sheets using this valuation model. This stage is essential because it allows you to further filter your stocks. You may sometimes want to choose other stocks, or stocks of closest company peers, as they may look better based on financial ratios.

Stage 3 Portfolio Building.

After previous stage, you should have around 4-5 equities left—stocks that look better than their closest peers, companies that are strong fundamentally, with growing revenues, declining costs, stable and high gross/operating margins, and strong financial ratios. Moreover, your selected stocks should have good growth potential, the stock target price should exceed its market price by at least 15%, and the company should have strong management, with a great vision and experience, as this will be an additional attractor for investors.

The next stage is to build an efficient investment portfolio. An efficient investment portfolio is one where assets, in our case stocks, are allocated so that traders achieve minimized risk under their required return or maximized expected return under their identified level of risk. To build an efficient investment portfolio, you can use different portfolio management models, such as the Markowitz model. There are also different web-based applications that can help you build an efficient investment portfolio. However, if you want to build an efficient investment portfolio manually, the process is time-consuming, as you need to extract stock closing prices for an extended period to make your asset allocation more accurate—this could involve 5 years of stock trading data. You extract stock closing prices for each stock that you selected, then calculate the percentage return for each day, and then build a variance-covariance matrix based on percentage changes. The Variance-Covariance matrix shows the dependence of each stock in your portfolio, allowing you to see each asset's correlation and the strength of this correlation—how strongly they move together. Then, you calculate the portfolio return, which is a weighted average return. Take each stock's weight in the portfolio and multiply it by each individual stock's return for the period. At this stage, you can assign random stock weights, as we will perform this calculation later. The next step is to calculate portfolio variance using data from the variance-covariance matrix. Following this, you calculate the portfolio's standard deviation, which is simply the square root of the variance. The last step is very important—you allocate stock weights to minimize standard deviation or maximize the return. If you are building your efficient portfolio in Excel, you can use Excel's Solver tool for efficient weight allocation. I have a detailed guide on how to allocate asset weights in Excel.

Some traders don't want to spend time manually building an efficient investment portfolio. In this case, they may choose to buy an ETF. An ETF is a financial instrument issued by brokerage companies that tracks the performance of different assets. There are different ETFs, some track stocks, like SPY or IWM, some track commodities or FX, and others track a mix of financial instruments. When traders buy an ETF, they buy a well-diversified investment portfolio, and investment banks are responsible for building, rebuilding, and managing this portfolio. The return of an ETF is the weighted average return of each asset the ETF tracks. This can be a good option for passive investors or those without time to build and rebuild an efficient investment portfolio manually. For those interested in choosing ETFs, I have written a detailed guide on ETF selection.

Stage 4 Risk Management.

At this stage, you should already have an efficient investment portfolio and know the weight of each asset in your portfolio. The next step is to understand your risk.

• Traders can start with the Value-at-Risk (VaR) model, which shows the potential maximum loss of your portfolio over a specific period. VaR can be used to calculate both individual stocks' maximum loss and portfolio loss.
• Another valuable model that traders can employ is the Monte Carlo simulation. This model simulates stock returns over a large time interval, usually 10,000 days, and then calculates the probability of stock returns falling within a particular range. For example, this model might indicate that a particular stock has a 90% probability of returns falling within a 4%-7% range. By using this model, you can understand how risky your portfolio or an individual stock is. If it doesn't meet your risk appetite, you can replace the stock with another asset and repeat from the first stage. This model is also useful for setting Stop-Loss and Take-Profit levels for your stock. If you understand your stock's trading range, you can place your Take-Profit slightly above this range and a Stop-Loss at about half that range below your purchase price. For example, if the Monte Carlo simulation model shows a 90% probability that your stock will trade within a 4%-7% range, you can place your Take-Profit 8% above your purchase price and your Stop-Loss 4% below your purchase price.

Stage 5 Technical Analysis.

At this stage, you already know your stocks' loss probabilities and exactly how much of each asset should be in your investment portfolio in percentage terms. Now it's time to understand when to buy your stock. For that, you can use different technical indicators, such as the Exponential Moving Average (EMA) or Volume Weighted Average Price (VWAP), to identify the best time to buy your selected stock. You can also use simple apps, such as Stocks 2 BuyEMA API endpoint to fetch data in JSON format.

Stage 6 Buying Selected Stocks.

When you have defined good entry (purchase price) and exit points (Stop-Loss and Take-Profit), it's time to buy your selected shares. In your trade terminal, you can use simple purchase orders, such as buying at market (buying the stock at the current market price), buying at limit (buying your stock below the current market price—this order will be executed when the stock price reaches your indicated price), a Stop Order (to buy at a price higher than the current market price, which will be executed once the current price reaches your set price), or a Stop-Limit Order. In this type of order, you also set a maximum purchase price, below which your order will not be executed. This is very useful for trading stocks that are prone to gaps or high volatility. For larger volumes, you can use more sophisticated trade orders to lower trading costs and get the best execution. For example, the VWAP trade algorithm divides your trade volume into smaller parts, aims to execute trades at an average price based on the volume traded over a specific time period, or you can use TWAP, which executes orders at defined time intervals, such as every 10 minutes. This approach is useful for trading larger volumes without causing significant price movement or revealing a strong buying intent.

Stage 7 Portfolio Rebalancing.

At this stage, you already have stocks in your portfolio allocated based on the Markowitz model, value stocks that look better than closest peers, and you know your expected market risk. You also know when you're planning to sell your stocks based on Stop-Loss and Take-Profit levels. However, sometimes you need to rebalance your portfolio, and this is a very important stage. Portfolio rebalancing is done for various reasons. Sometimes stocks in your portfolio become more volatile and are no longer aligned with your risk appetite. Other times, company fundamentals change (for the worse), prompting you to sell. Sometimes your portfolio stops being efficient because stock trading parameters change—they become more volatile, start trading with gaps, or trading volumes drop. To check your portfolio's efficiency, you can use the Sharpe ratio. This ratio shows your portfolio's return adjusted to risk-free rates and volatility. You should choose the portfolio with the highest Sharpe ratio.

By now, you know how to choose stocks, calculate their expected risk, and build an efficient investment portfolio to minimize your loss given your required return. You also know when is the best time to buy and sell your selected stock and when to rebalance your investment portfolio. I hope this guidance has been useful. However, always remember that stock risk, or market risk, is sometimes called uncontrollable risk because it cannot be fully eliminated. There are many factors that influence stock price formation, so no one can forecast the stock price accurately. Always rely on your own assumptions, gather market information, calculate your risks, choose value stocks, and try to hold them for the long term. Only then will you have higher chances of generating positive returns over the long term.