When purchasing common stocks, the name of the game is risk avoidance.  If you avoid losing money, you stand to do well in the stock market.  You buy a stock to achieve a return, but achieving a return depends on buying quality stocks when they are trading at bargain prices.  That is, you make a good stock investment when you buy stock in a solid company that is underpriced.  When you do this, you have minimized risk by minimizing your potential loss.  If you want to achieve good returns consistently, don’t focus your attention on the possible return; focus on minimizing your risk of loss when you buy.

To reduce the risk of loss when you buy, you want to place the main emphasis on understanding the equity position of the company.  The equity of the company is revealed and decomposed on the balance sheet.  Expected profits should be treated as a secondary consideration when you buy stocks.

Why can’t I just focus on the expected profits to help me know when to buy?  I mean, what if I want to make ten percent on my money and the company is predicted to earn one dollar per common share next year…..wouldn’t it be a great deal if I could buy a share in that company for less than ten dollars?  (Since $1 of earnings / $10 invested = 10 percent, the return would be higher than my desired 10 percent if I could pay less than ten dollars to achieve that one dollar return).

The short answer on whether it would be a great deal: “Not necessarily; much risk is still present when you focus primarily on the potential return to know when to buy.”  What if the company earns fifty cents per share next year instead of the forecasted one dollar per share?  Where will the stock price be then?

There’s only one way to protect against an expected reward not panning out.  When you are buying stocks, you must lessen the emphasis you place on the possible return and increase the emphasis you place on minimizing your risk of loss that could result from unforeseen events challenging the company after you buy.  How do you do this?  You focus on evaluating the Stockholders’ Equity on the balance sheet of the company.

My book, “Choose Stocks Wisely” seeks to offer a detailed explanation of my simple approach to buying quality stocks at bargain prices by using the balance sheet to minimize risk when I buy.