HOW TO INVEST IN STOCKS

"Know what you own, and know why you own it." — Peter Lynch

1. THE PORTFOLIO

What is it?

At its simplest, a portfolio is a collection of financial assets: shares, bonds, mutual funds and so on. The point of a portfolio is to spread your money around to reduce risk while still aiming for the best possible return.

Before we get to structures, it is worth being clear about why we invest for the long term: compounding. A portfolio does not grow in a straight line; it grows on top of what it has already grown. And the gap between a mediocre return and a good one, sustained over decades, is enormous.

Fig. 1Time does the work

"The big money is not in the buying or the selling, but in the waiting." — Charlie Munger

How is it structured?

There are several ways to structure a portfolio, depending on what the investor wants to achieve and how much risk they can stomach. These are the most common:

Structure	Goal	What it holds	Risk	Typical investor
Growth	Long-term capital gains	Companies growing sales and EPS by 20%+	High	Young investor, 10+ year horizon
Income	Passive income	Stocks with steady dividends, bonds	Low	Retiree living off coupons and dividends
Growth and income	A balance of both	A mix of growth stocks, dividend payers and bonds	Medium	45-year-old who wants growth without scares
Value	Buy below intrinsic value	Companies with low P/E and P/S for their sector	Medium	Patient investor, happy to go against the crowd
Arbitrage	Profit from price gaps	The same assets across markets or instruments	Low per trade, high in execution	Professional with very low costs

First define your investment objective, then work out your risk tolerance, and only then choose the structure that best fits. Once chosen, stick with it. If your risk tolerance or objective changes significantly, start a new portfolio, or at least treat the change as a new portfolio, rather than reshaping the old one.

An example: you start with a growth portfolio and, after a 20% drop, you begin buying dividend stocks "to feel calmer". Now you have neither a growth portfolio nor an income one, just a mix with no logic that you will not be able to evaluate. If your risk tolerance really has changed, open a new portfolio and measure each one separately.

My own view is that the best approach is a growth portfolio with a few value stocks and a few shorts (bets against stocks we think will fall), keeping sector exposure diversified and focusing on US mid and large caps (at least $1B in market capitalisation).

How is it managed?

Managing a portfolio means supervising it and regularly checking how its holdings are performing, at least daily or weekly depending on how much time you want to give it. The aim is to keep risk and return in balance and make sure the holdings stay within the investor's risk tolerance.

Management also includes rebalancing: adjusting the portfolio's make-up to keep it true to its original structure. This keeps the portfolio efficient and lets it reflect changes in the investor's preferences or in the economic backdrop.

We will change the portfolio on these occasions:

a) When we build the initial portfolio.

b) When the fundamentals of an investment change (earnings, market share and so on; the example "Trade Ideas" make this clearer).

c) When market conditions change (we turn bearish or bullish).

And, by elimination, we will not change it because a stock fell 10% in a week with nothing changing at the company, or because "everyone" is buying something else.

2. INVESTING AND TRADING: TWO DIFFERENT JOBS

Investing and trading use the same tools (shares, charts, quarterly results), but they are different jobs, with different questions and different mistakes. Mixing them up is one of the most common ways to lose money.

Investing is buying a piece of a business. Over the long run, a stock's return is explained almost entirely by three things:

Return ≈ EPS growth + dividend ± change in P/E

If a company grows its EPS by 15% a year for 5 years and the market keeps paying the same P/E for it, the stock multiplies by 1.15⁵ ≈ 2. Nobody has to change their mind: the business just has to deliver.

Trading is betting on a price move over a short period. In 3 months, a company's EPS barely changes; what moves the stock is the third term, the P/E, in other words what the market is willing to pay. And that depends on surprises, expectations and sentiment. That is why a trader needs a catalyst: a dated event that forces the market to change its mind.

	Trading	Investing
Horizon	Days to 3 months	5 years or more
The question	What will happen at the next event, and how will the price react?	Where will this business be in 5 years?
Where the return comes from	Change in P/E (surprise, sentiment)	EPS growth and dividends
What we analyse	Catalysts, consensus estimates, positioning	Sales, margins, market share, debt, management
When we exit	When the catalyst plays out (or fails)	When the fundamentals change
Stop loss	Essential	Unnecessary without leverage
Decisions per year	Dozens or hundreds	Very few
Typical tools	Shares and options	Shares
Typical mistake	Holding a losing trade "for the long term"	Selling a great company over one bad quarter

An example with the same company. A software company reports results in three weeks:

• The trader studies what the consensus expects, believes sales will beat, and buys before the results. If the stock rises 12% the next day, they sell. If it falls, they sell too: the thesis was the event, and the event is over.
• The investor bought two years ago because the company grows 25% a year, its margins rise every year and it has 3% of a huge market. If the stock falls 12% after a weak quarter, they ask one question only: has any of that changed? If not, they do nothing (or buy more).

The most expensive mistake is crossing the wires: buying as a trader and, when the trade goes wrong, deciding that "now it's a long-term investment". A losing trade does not turn into an investment; it turns into a position with no thesis.

"If you aren't willing to own a stock for ten years, don't even think about owning it for ten minutes." — Warren Buffett

A practical detail: taxes. In the US, gains on positions held for less than a year are taxed as ordinary income, far more heavily than long-term gains. In Spain the rate does not depend on the holding period, but selling often brings the tax bill forward: the investor who does not sell lets all of their money keep compounding, while the trader pays every time they are right.

This guide is mostly about investing. Trading has its place (and it is where options make most sense, as we will see in section 7), but you should always know which job you are doing.

3. IDEA GENERATION

There are three main ways to find ideas. They are not mutually exclusive: usually you combine them.

Method	Starts with	Key question	Strength	Risk
Top-down	The economy	Which sectors benefit from the current cycle?	Avoids fighting the market	Right sector, wrong company
Bottom-up	The company	Is this an exceptional business?	Finds gems nobody is watching	Ignoring a hostile macro backdrop
Themes	A trend	Who wins and who loses from this change?	Captures multi-year moves	Overpaying for a fad

The top-down method

This approach looks first at macroeconomic conditions and only then at the specific fundamentals of an investment. It starts by assessing the global economy and markets, weighing factors such as GDP growth, inflation, interest rates and credit conditions.

Next, it looks at how different sectors and countries are performing, to find those with growth potential that offer the best investment opportunities.

Finally, individual stocks are picked within those sectors and countries on the strength of their growth potential and financial fundamentals. This gives investors a view of the whole economy and market, so they can decide with confidence where to invest and how much.

An example, step by step:

1. Macro: inflation eases and the central bank starts cutting rates.
2. Sector: the most rate-sensitive sectors, such as housing, benefit: mortgages get cheaper and demand returns.
3. Industry: within housing, the builders of new homes (homebuilders) rather than materials suppliers.
4. Company: among the homebuilders (DHI, LEN, PHM...), the one with the fastest EPS growth, rising gross margins and the least debt.

The bottom-up method

This approach works the other way round: first the specific fundamentals of an investment, then the macroeconomic picture. It starts with a company's fundamentals, such as its management, its products and services, and its competitive position. Only then are the economy and markets assessed to judge whether the company is a good investment.

"Behind every stock is a company. Find out what it's doing." — Peter Lynch

An example: Costco (COST). Starting from the bottom, we see a business that charges its members an annual fee, and more than 90% of them renew year after year. That means almost guaranteed revenue, loyal customers and enormous bargaining power with suppliers. Only then do we ask about the backdrop: does this model hold up in a recession? (Yes: in hard times people look for low prices.)

Themes or Trends

This method means spotting the "trends" or "themes" affecting a particular sector or company. Once you have the theme, you analyse the companies in that sector or industry to find which one has the "juice", that is, which will give us the best return.

For "longs", that means looking for the companies with the most growth potential; for "shorts", those most at risk of losing value because of the theme.

In my view it is the most powerful way to generate ideas, because themes are what produce the big moves: the ones that multiply a stock 5 or 10 times in a few years, or sink it for good. So we will go through it in much more detail, with real data.

What a theme is (and is not)

A theme is a structural change that forces a lot of people to spend their money differently for years. It is not a news story, a good quarter or a social media craze. To tell them apart, these are the questions I ask:

Question	A real theme	A fad
How long does it last?	Years or decades	Weeks or months
Does it move real money?	It shows up in the sales and guidance of many companies	It shows up in headlines, not in earnings
Who pays?	Companies and governments with huge budgets	Individuals with spare cash
Does it have losers?	Yes: someone stops selling what they used to sell	No: nobody loses, so probably nothing is changing
Are there bottlenecks?	Yes: capacity is short and suppliers raise prices	No: supply is plentiful

The fourth question is the most useful: if you cannot find anyone who loses from the theme, be suspicious. Real changes always have victims, and those victims are our shorts.

The life of a theme

Themes follow a fairly predictable cycle, and knowing which stage you are in matters as much as getting the theme right:

Fig. 2The life of a theme

1. Born: few people see it and the numbers are still small. High risk, but the price discounts almost nothing.
2. Obvious winner: the market identifies the protagonist (NVIDIA in AI, Tesla in electric cars) and re-rates it hard.
3. Second order: the market starts asking who the obvious winner buys from: suppliers, infrastructure, raw materials. This is usually where the best opportunities are, because fewer people are looking.
4. Consensus: everyone owns the theme, there are thematic ETFs and magazine covers. The theme is in the price.
5. Maturity or disappointment: growth normalises, or adoption turns out slower than expected. The stocks that were priced as if the future were certain suffer.

First, second and third order

The most profitable idea I know for working themes is to follow the money along the supply chain. If the theme is "everyone wants to train AI models", the first order is the chips that do the work. But those chips need memory, the data centres that house them need electricity, and that electricity increasingly comes from nuclear plants that need uranium.

Here is how many times each link has multiplied since ChatGPT's launch:

Fig. 4The same theme, link by link

Micron, which sells the memory GPUs need, has done better than NVIDIA (×19.1 against ×13.3). Vistra, a power company, has multiplied 6 times. All of them have comfortably beaten the S&P 500 (×2.0). The question that opens up the second order is always the same: what does the obvious winner have to buy, and who sells it to them?

Example 1: artificial intelligence

Artificial intelligence (AI) is revolutionising industry: which companies are leading the revolution, and which are being hurt by it?

• We could say that semiconductor stocks (NVDA, AMD, ARM) have benefited from AI, as they are among the companies leading this revolution. Careful, though: not every chipmaker won. Intel, late to AI chips, lagged for years. Within the theme, you have to choose.
• But we could also say that others have been hurt, such as traditional education companies (CHGG, COUR). These would be our potential "short ideas".

Chegg is the textbook case. Its business was helping students with homework for a subscription. On 2 May 2023 the company itself admitted that ChatGPT was slowing its new customer growth, and the stock fell 48% in a single day. It never recovered:

Fig. 3AI: the obvious winner, the less obvious one and the loser

Look at the three lines: the obvious winner (NVIDIA) multiplied 13 times; the second-order winner (Micron), 19 times; and the obvious loser (Chegg) lost more than 97%. A long NVDA / short CHGG pair would have made money on both sides.

Example 2: GLP-1 drugs

Medicines such as Ozempic, Wegovy, Mounjaro and Zepbound are changing what millions of people eat. It is a textbook theme: real money (they are among the best-selling drugs in the world), for years, with bottlenecks (for a long time not enough could be made) and with clear losers.

• Obvious longs: the two makers, Eli Lilly (LLY) and Novo Nordisk (NVO).
• Possible shorts: traditional weight-loss programmes (WW International, which ended up filing for bankruptcy in 2025) and, one step removed, snack and fast-food companies if consumption falls.

And here comes the most important lesson of the chapter: being right about the theme is not enough.

Fig. 5GLP-1: being right about the theme is not enough

Both makers were on the right side of the theme. But Lilly won market share with Mounjaro and Zepbound, while Novo cut its guidance and changed CEO in 2025. The result: since Wegovy's approval, Lilly has multiplied 5.4 times and Novo is back where it started, behind the S&P 500, after falling 71% from its peak. That is why, once the theme is identified, the fundamentals of section 6 take over again: sales and EPS growth, margins and, above all, who is winning market share.

Example 3: electric cars, and the price of euphoria

The adoption of electric vehicles: which companies are leading the revolution, and which are being hurt by it?

• We could say that Tesla (TSLA) has benefited from the adoption of electric vehicles, as it is one of the companies leading this revolution.
• But we could also say that others have been hurt, such as fossil fuel producers (CVX, XOM). These would be our potential "short ideas".
• We could also take a more contrarian view of the theme, essentially the opposite: what if the shift to electric vehicles is not as inevitable, or as fast, as we think?
  • In that case, fossil fuel producers (CVX, XOM) could be a good investment, as they still have plenty of growth potential and are highly profitable.
  • Meanwhile, electric vehicle makers (TSLA, NIO, BYDDF) could suffer if the transition turns out slower than expected.

This example teaches stage 4 of the cycle. In November 2021, electric cars were total consensus: Tesla was worth more than the next several carmakers combined. Anyone who bought the theme through its obvious winner then paid a price that already discounted years of success:

Fig. 6Buying the theme at peak euphoria

Five years later, Tesla is where it was, while the contrarian thesis (Exxon) has multiplied 3.2 times and the S&P 500 1.8 times. The theme was not wrong: electric cars sell more every year. What was wrong was the entry price.

"The four most dangerous words in investing are: 'this time it's different'." — John Templeton

Example 4: electricity for data centres

Training and running AI models uses an enormous amount of energy, and the US power grid had not grown in decades. It is the second order of AI in its purest form:

• Longs: power producers with spare capacity (VST, CEG) and the uranium chain behind nuclear power (CCJ).
• The interesting part is that for years these were the dullest stocks in the market (utilities, "widows and orphans" stocks). When the theme reached them, nobody owned them, and that is exactly what we look for: a powerful theme arriving at stocks the market does not yet associate with it. Since ChatGPT's launch, Vistra has multiplied 6.0 times, Cameco 3.6 and Constellation 2.8.

How to find the next theme

Nobody is going to tell you. These are the sources that have served me best:

1. Earnings calls. When the CEOs of companies in different sectors start mentioning the same thing, quarter after quarter, something is there.
2. Big companies' capex. What the world's largest companies plan to spend is, literally, their suppliers' future revenue.
3. Bottlenecks. When something is scarce (chips, memory, electrical transformers, capacity to make a drug), whoever makes it can raise prices, and that goes straight to margins.
4. Regulators. An FDA approval, a law or a subsidy can create a market overnight.
5. The second-order question. For every theme that is already consensus: who sells to the obvious winner?

Themes at a glance

Theme	Longs	Shorts	What happened	Lesson
Artificial intelligence	NVDA, MU	CHGG	MU ×19.1, NVDA ×13.3, CHGG −98% (since Nov 2022)	The second order can beat the first
GLP-1 drugs	LLY, NVO	WW	LLY ×5.4, NVO ×1.0 (since Jun 2021)	Getting the theme right is not enough: pick the winner
Electric cars, at the euphoria	TSLA	XOM	TSLA ×1.0, XOM ×3.2 (since Nov 2021)	The entry price matters as much as the theme
Power for data centres	VST, CEG, CCJ	—	×6.0, ×2.8, ×3.6 (since Nov 2022)	Look for the theme in stocks nobody associates with it

Data from Yahoo Finance, adjusted monthly closes, to September 2026.

Finally, remember the distinction from section 2: a theme can be worked as an investment (for years, following the companies' fundamentals) or as a trade (around a specific catalyst, such as results or an approval). For investments we do not need catalysts; we focus far more on fundamentals, such as earnings growth, market share and how debt is evolving.

4. RISK MANAGEMENT

What is it?

Risk management is the process of identifying, assessing and mitigating the risks of an investment or portfolio. Its aim is to protect capital and maximise returns by keeping potential losses within acceptable limits. Put simply, it is a set of steps we can take to sleep better at night.

Steps we can take

Diversification

Diversification means investing across a range of assets or sectors to reduce risk. Watch the market for a while and you will notice some quirks. Sometimes one sector does very well; at other times the market as a whole seems flat, when in fact some sectors are collapsing and others are soaring.

So one thing we can do is diversify the portfolio to take advantage of this. Ideally, we are long the sectors that are rising and short the ones that are falling. Easier said than done, of course.

A common approach is this: say we have a very simple portfolio of 6 positions, and we want to express the view that technology will rise and energy will fall.

The best we can do is:

• Go long 2 technology companies and short 1 technology company.
• Go short 2 energy companies and long 1 energy company.

Fig. 7Longs and shorts by sector

TechnologyLLS

EnergySSL

L = long · S = short

This way we profit from the rise in technology while a short protects us if it falls, and at the same time we profit from the fall in energy while a long covers us if it rises.

Let's see what happens in numbers, assuming $10,000 per position, in three scenarios. In each sector we pick the best companies as longs and the worst as shorts, so even when the whole sector moves against us, our longs do better than our shorts:

Scenario	Technology (2L + 1S)	Energy (2S + 1L)	Result
We're right: tech +20%, energy −20%	Longs +25%, short +10% → +$4,000	Shorts −25%, long −10% → +$4,000	+$8,000
Everything rises 15%	Longs +20%, short +10% → +$3,000	Shorts +10%, long +20% → $0	+$3,000
Everything falls 15%	Longs −10%, short −20% → $0	Shorts −20%, long −10% → +$3,000	+$3,000

When the thesis is right we make a lot, and when the whole market moves in one direction, the hedge cancels the move and what is left is what we earned by picking the right companies.

Losses weigh more than gains

Here comes the cruellest arithmetic in investing: losses and gains are not symmetrical. If you lose 50%, you do not need to make 50% to get back; you need 100%.

Fig. 8Losses weigh more than gains

"Rule No. 1: Never lose money. Rule No. 2: Never forget rule No. 1." — Warren Buffett

Stop Loss

A stop loss is an automatic sell order placed to limit losses on an investment. In my view, if we are not using leverage (that is, borrowing money to invest), a stop loss is not necessary.

The reason is that, without leverage, a temporary fall never forces us to sell: we can wait for the fundamentals to do their work. With leverage, on the other hand, falls are multiplied and the broker can close the position for us (a margin call) at exactly the worst moment:

Stock move	No leverage	2× leverage	3× leverage
+20%	+20%	+40%	+60%
−10%	−10%	−20%	−30%
−25%	−25%	−50%	−75%
−33%	−33%	−66%	−99% (almost everything gone)
−50%	−50%	−100% (everything gone)	You lose more than you had

"The market can stay irrational longer than you can stay solvent." — attributed to John Maynard Keynes

5. CONCENTRATION, DIVERSIFICATION AND REDUNDANCY

The case for concentrating on conviction

Your best idea is better than your twentieth. It sounds obvious, but it has an awkward consequence: every position you add to the portfolio is, by definition, an idea you like less than the ones you already own. Diversifying is, to a large extent, taking money from your best ideas and giving it to your worst.

And the effect is huge. Imagine you are spot on and your best idea doubles:

Fig. 9How much your best idea weighs

With 5 positions, that win lifts your portfolio 20%: it changes your year. With 50, it moves it 2%: all the work of finding that idea is buried under 49 others.

There is also a deeper fact that favours concentrating. Professor Hendrik Bessembinder studied every listed US stock from 1926 to 2016 and found that about 4% of them account for all the net wealth the US stock market created over those 90 years. Most stocks, over their lifetimes, did worse than Treasury bills. Stock market returns are not spread out: they are concentrated in a few enormous winners. And if you own one of those winners at 2% of the portfolio, you will barely notice.

The greatest investors in history have worked this way. Buffett came to hold close to half of Berkshire Hathaway's stock portfolio in a single company, Apple. Keynes, who besides being an economist successfully ran the fund of King's College, Cambridge, explained it in a 1934 letter:

"As time goes on, I get more and more convinced that the right method in investment is to put fairly large sums into enterprises which one thinks one knows something about and in the management of which one thoroughly believes." — John Maynard Keynes

That said, concentration only works if the conviction is real. Conviction is not "I really like this stock": it is having done the work. One way to tell them apart:

	Real conviction	False conviction
Where it comes from	Your own analysis of sales, margins, market share and valuation	A video, a forum, or the stock "not stopping going up"
Do you know what would change your mind?	Yes, and you have it written down	No, or the answer is "nothing"
Do you know the opposing thesis?	Yes, and you know why you think it is wrong	You have not looked for one
If the stock falls 30% with no news	You check the thesis and, if it still stands, buy more	You sell, or you cannot sleep
Could you explain it in two minutes?	Yes	Only with adjectives

And concentrating does not mean owning a single stock. It means the size of each position reflects your conviction: a lot of money in the 3 or 4 ideas you know best, somewhat less in the next ones, and no "filler" positions that are only there to add tickers.

"Put all your eggs in one basket and watch that basket." — Mark Twain

The case against diversification

Peter Lynch coined a word for what happens to most portfolios: "diworsification". Beyond a certain point, each new stock does not reduce risk; it only reduces returns and adds work. The arguments:

1. If you buy 40 stocks, you have bought the index, but at a higher price. With enough positions, your portfolio will look like the S&P 500, but you will have paid more in fees and spent hundreds of hours. If what you want is the index, buy it directly for a fraction of the cost.
2. You cannot follow 40 companies. Each reports 4 times a year: that is 160 quarterly reports, with their earnings calls, guidance and competitors. Nobody with another job can do that well. With 8 or 10 companies, you can.
3. Averaging bad ideas does not improve them. Diversification protects you from what you do not know, but it also stops you from profiting from what you do know.
4. The false sense of security. Owning many tickers feels like being protected. As we will see now, it is often just the same bet repeated.

"Diversification is protection against ignorance. It makes little sense if you know what you are doing." — Warren Buffett

Buffett's line has two readings, and both are true. If you are not going to do the work of studying companies, diversify as much as possible: buy the index and forget about it. But if you are going to do the work, diluting it across 40 positions throws it away. What makes no sense is the middle ground: picking stocks one by one without studying them, and holding so many that the result ends up being the index's.

The absurdity of redundancy

There is a mistake even worse than over-diversifying: believing you are diversified when you are not. The most common example today is this portfolio:

• A third in Alphabet (GOOGL), "because search and the cloud are a great business".
• A third in NVIDIA (NVDA), "because AI is the future".
• A third in the Nasdaq-100 (QQQ), "to be diversified".

Three different tickers, so they look like three different things. But QQQ is not "the market": it is a fund that, among other things, holds NVIDIA and Alphabet among its largest positions. Look inside, and this is what the portfolio actually owns:

Fig. 10GOOGL + NVDA + QQQ: what you actually own

71% of the money is in two companies. And they are not even two different bets: Alphabet is one of the biggest buyers of AI chips, NVIDIA is who sells them, and QQQ is full of both. If one day the market decides too much has been spent on AI, all three positions will fall together. Whoever holds this portfolio does not have three investments: they have one, repeated three times.

Other very common redundancies:

Combination	What it looks like	What it really is
VOO (S&P 500) + QQQ	"The market + extra tech"	NVIDIA, Apple and Microsoft weigh practically the same in both funds (≈8.2%, 7.4% and 5.6%)
S&P 500 + MSCI World	"The US + the rest of the world"	The US is more than 70% of the MSCI World: mostly the US, twice
VTI (total US) + VOO (S&P 500)	"The whole market + the big ones"	The S&P 500 is about 80% of the total US market
NVDA + AMD + a semiconductor ETF	"Three bets on chips"	A single bet: the semiconductor spending cycle
Dividend ETF + KO + PG + JNJ	"Diversified income"	The same defensive stocks, twice

How to spot it, in two steps:

1. Look through the ETFs. Add up your exposure to each company, both what you own directly and what you own inside each fund. If a single company exceeds what you would be willing to hold in it on purpose, you have a problem.
2. Ask what has to happen for each position to rise. If the answer is the same for two positions ("AI spending continues"), they are a single position, even if they have different tickers.

Real diversification is not owning many tickers: it is owning bets that depend on different things. And real concentration is not owning few tickers: it is knowing exactly what your bet is and choosing its size on purpose.

Indices need studying too

Many people spend weeks studying a stock before buying it and then put half their money into an ETF without knowing what is inside. But an index is not "the market": it is a set of rules someone wrote, and those rules decide what you buy. It needs studying just like a company.

First, what is inside and how much each thing weighs:

Fig. 11An index is not “the market”

Whoever buys the S&P 500 "to own 500 companies" has almost 40% of their money in 10. Whoever buys the Nasdaq-100 has almost half in 10. And if we compare their largest positions, the surprise is how alike they are:

Position	QQQ (Nasdaq-100)	SPY (S&P 500)
NVIDIA	8.17%	8.17%
Apple	7.40%	7.37%
Microsoft	5.58%	5.56%
Micron	5.09%	1.83%
AMD	4.28%	1.54%

Holdings as of 24 and 25 September 2026. The three largest weigh exactly the same; QQQ's real difference is that it holds three times as much in chipmakers such as Micron and AMD. That is what you buy when you buy QQQ, not "technology".

Second, the index's philosophy: who decides what goes in, under what rules, and how it is weighted. The differences are large:

Index	Companies	How it weights	Who decides what goes in	Worth knowing
S&P 500	≈500	By market cap	A committee, which requires positive earnings	Tesla only joined in December 2020, when it was already one of the largest companies in the country, because it had no profits
Nasdaq-100	≈100	By market cap, with concentration limits	Rule: the 100 largest non-financial companies listed on Nasdaq	It is not a "tech" index: it includes Costco and PepsiCo, and excludes banks and everything listed on the NYSE. In July 2023 it needed an emergency rebalance because a few companies weighed too much
Dow Jones	30	By share price	A committee	A stock trading at $500 weighs five times as much as one at $100, whatever the size of the company
Russell 2000	≈2,000	By market cap	Rule: US companies ranked 1,001 to 3,000 by size	They are small companies, and a large share of them have no profits
MSCI World	≈1,400	By market cap	Rule: developed countries only	"World" without China, India or any emerging market, and with the US at more than 70%

And third, the questions I ask before buying any index, which are almost the same as for a stock:

1. What are its 10 largest positions and how much do they weigh in total?
2. How does it weight: by market cap, by price, equally?
3. What does it leave out, and why?
4. Which sectors dominate? What has to happen for it to rise?
5. How much does it overlap with what I already own?
6. How much does it cost each year?

If you cannot answer them, you have not bought "the market": you have bought something you do not know.

6. FUNDAMENTAL ANALYSIS

Basic concepts

Earnings and Earnings Growth Estimates (EPS)

Earnings are what a company makes after deducting its costs from its revenue. They are usually expressed as "Earnings per Share" (EPS), the profit the company makes for each share, which "normalises" the comparison between companies of different sizes.

For example: a company earns $2 billion in a year and has 500 million shares. Its EPS is $2,000M / 500M = $4 per share. Another company earns twice as much, $4 billion, but has 2 billion shares: its EPS is only $2. It earns more in total, but less for each share you own.

Earnings growth estimates are what analysts expect a company's earnings growth rate to be over a future period. As a rule, for our longs we favour the company with the fastest earnings growth, and for our shorts the one with the slowest (or most negative).

Price/Earnings (P/E)

The Price/Earnings (P/E) ratio measures a share's price relative to the company's earnings. It is calculated by dividing the share price by EPS. A high P/E can mean investors expect strong earnings in future, while a low P/E can mean investors are valuing the company with a margin of safety.

For example: if the stock above trades at $100 and its EPS is $4, its P/E is 100 / 4 = 25. Put another way: you are paying for 25 years of today's earnings. If earnings grow, those 25 years become far fewer.

In general, a higher P/E can signal greater confidence in the company's growth prospects, while a lower P/E can point to steadier growth, or even a company in trouble.

IMPORTANT NOTE: Contrary to popular belief, a high P/E does not necessarily mean a stock is "expensive" or "very expensive", and a low one does not make it "cheap" (in fact, those are considered dirty words in finance). A high P/E can mean investors expect strong earnings in future, which may be a good sign that the company is growing and has room to grow further.

The chart shows it better than any explanation. Two companies: A trades at a P/E of 40 and grows 30% a year; B trades at a P/E of 12 and does not grow. "A is expensive and B is cheap", right?

Fig. 12A high P/E is not expensive if EPS delivers

If A meets expectations, within five years you will have paid fewer times its earnings for it than for B. What matters is not today's P/E, but whether the growth it prices in actually happens.

"Price is what you pay. Value is what you get." — Warren Buffett

Price/Sales (P/S)

The Price/Sales (P/S) ratio measures a share's price relative to the company's sales. It is calculated by dividing the share price by sales per share or, equivalently, market capitalisation by the company's total sales.

For example: a software company is worth $30 billion on the market and sells $3 billion a year. Its P/S is 30,000 / 3,000 = 10. If it is still losing money, its P/E does not exist (it is negative), and P/S is the only way to compare it with its rivals.

IMPORTANT NOTE: On its own, P/S does not usually tell you much. We often fall back on it to compare companies that are still loss-making (negative P/E).

Revenue or Sales Growth

"Sales Growth" is the rate at which a company's sales grow over a given period. It is calculated by dividing one period's sales by the previous period's and subtracting 1. Strong sales growth can be a sign that the company is expanding and has solid growth potential. Weak sales growth can be a sign that growth is slowing or even stalling.

For example: if a company sold $500 million last year and $600 million this year, its sales growth is 600 / 500 − 1 = 20%.

The interesting part is the trend, not a single number:

Year	Sales	Growth	Reading
Year 1	$500M	—
Year 2	$650M	+30%	Strong growth
Year 3	$800M	+23%	Still strong, but slowing
Year 4	$900M	+13%	Clear deceleration
Year 5	$950M	+6%	The market is maturing

This company still sells more every year, but a stock the market valued for growing 30% will struggle to hold its P/E growing 6%. Deceleration is often one of the best signals for a short.

Addressable Market and Market Share

"Market Share" is the proportion of total sales of a product or service in a given market that a company captures. The "Addressable Market" is the total size of the market a company can sell into.

An example of how we use this: If a company is growing fast and has $8B in sales, while the market, or "Addressable Market", is only $10B and growing at 1% a year, its Market Share is 80%: the company already has 80% of the market.

Fig. 13Market share

Here our first impression might be that the company is excellent and a good investment, but its Market Share shows it is already very high, with little room to grow (now or later). That is why it matters so much to analyse a company's market share and compare it with its peers in the same sector.

Let's compare it with another, much smaller company, B:

	Company A	Company B
Sales today	$8B	$1B
Addressable market	$10B, growing 1% a year	$40B, growing 15% a year
Market share	80%	2.5%
Market in 5 years	≈$10.5B	≈$80B
Sales in 5 years at the same share	≈$8.4B (+5%)	≈$2B (+100%)
Sales in 5 years, best case	$10.5B with 100% of the market (+31%)	$4B with 5% of the market (+300%)

A is eight times bigger today, but B can double its sales without winning a single customer from a rival, simply because its market is growing. And if it also gains share, it can quadruple them.

Gross Margins

"Gross Margins" are the difference between the selling price of a product or service and the cost of producing it. What we mainly look at is the trend in these margins. Here is why they matter so much:

If a company has a 50% gross margin, then for every $1 of sales it keeps $0.50 after the cost of goods sold. Now imagine 2 companies, both with a 50% gross margin and both growing sales at 20% a year. However, Company A has held its margin at 50% for 10 years, while Company B has raised its margin by 5% a year over the same period.

After those 10 years, Company B's profits will be exponentially larger than Company A's, even though their sales grew at the same rate.

Fig. 14Same growth, different margin

This leads us to the following conclusion: Rising Gross Margins mean the company is making more on every dollar it sells, which can be a good sign that it is growing and has strong potential ahead. Falling Gross Margins, on the other hand, can mean the company is struggling to protect its profitability, perhaps because competition is increasing or production costs are rising.

A word of caution: margins are only comparable within the same sector. A supermarket with a 30% gross margin can be excellent, while a software company with the same 30% would be a disaster. Rough ranges:

Sector	Typical gross margin	Why
Software	70% – 85%	Selling one more licence costs almost nothing
Pharmaceuticals	65% – 80%	Making the pill is cheap; the research is what costs
Semiconductors	45% – 65%	Hugely expensive fabs, but products with real pricing power
Supermarkets and retail	20% – 35%	Reselling other people's products on thin margins
Carmakers	10% – 20%	Lots of materials, lots of labour, lots of competition

Metrics at a glance

Metric	How it's calculated	What it tells us	Signal for a long	Signal for a short
EPS growth	This year's EPS / last year's − 1	How fast earnings per share grow	+20% or more, accelerating	Low or negative, slowing
P/E	Price / EPS	How many years of earnings we pay for	High within a low-P/E sector	High with no growth to justify it
P/S	Market cap / Sales	Valuation of companies without profits	Low with fast-growing sales	High with slowing sales
Sales growth	This year's sales / last year's − 1	Whether the business is expanding	High and steady	Slowing quarter after quarter
Market share	Sales / Addressable market	How much room is left to grow	Low and rising, in a big market	High, or falling against rivals
Gross margin	(Sales − Cost of sales) / Sales	Pricing power and efficiency	Rising year after year	Falling on competition or costs

Conclusion

These are the most important metrics we consider when analysing an investment. We keep to a handful to avoid so-called "analysis paralysis": spending so long analysing an investment that you never make a decision.

In practice, if an investment has the basic hallmarks of a good one (sales growth, earnings growth, gross margin and so on), in most cases it will keep meeting those metrics over the long term.

What really matters is how these metrics evolve over time, and whether they are improving or deteriorating.

And, as ever, all this is learned with time. It is vital to keep a healthy scepticism and always be willing to change your mind.

Big changes in the metrics (or even the prospect that they might change) will make us rethink our positions, for better or worse.

Types of stocks

Growth stocks

A growth stock is one with high growth potential in sales, earnings and margins. These usually have high EPS growth estimates (+20% or more) and a high P/E, as the market is willing to pay more for them. (Remember: a high P/E does not make them expensive; the market is simply telling us it expects very strong EPS growth ahead, which is good!) Another key metric here is "Market Share", which should be rising, alongside an "Addressable Market" that is very large and growing.

Value stocks

A value stock is one trading at a low price relative to its intrinsic value. These usually have a low P/E, a low P/S and sales and EPS growth above the sector average. The best approach here is to look for the company with the highest P/E in a sector where P/Es are low. As we said earlier, a high P/E is a good sign, not a bad one! Alternatively, we can look for companies with a low P/S and sales and EPS growth above the sector average.

Defensive stocks

A defensive stock is one that holds up well when the economy is weak, because consumers and businesses keep buying its products and services even in hard times. Sectors considered defensive include Healthcare, Utilities, Aerospace and Defence. Nobody stops paying the electricity bill, buying toothpaste or taking their medication because there is a recession.

Cyclical stocks

A cyclical stock is one with high growth potential when the economy is strong, but which can suffer when it weakens. Sectors considered cyclical include Autos, Banks, and Oil & Gas. Changing your car, taking out a mortgage or expanding a factory are decisions that get postponed as soon as the economy cools.

Type	EPS growth	Usual P/E	In a recession	Typical sectors	Examples
Growth	+20% or more	High (30× or more)	Fall hard if growth slows	Software, semiconductors, cybersecurity	NVDA, CRWD
Value	Above their sector	Low	Depends on the sector	Banks, industrials, energy	JPM, CVX
Defensive	Steady, 3% – 8%	Medium	Hold up better than the market	Healthcare, utilities, consumer staples	JNJ, PG, DUK
Cyclical	Very volatile	Low at the peak, high at the trough	Fall hard	Autos, banks, oil, materials	F, CAT, XOM

A counterintuitive detail about cyclicals: their P/E tends to be lowest right at the best point of the cycle (when earnings are at their peak and the market already expects them to fall) and highest at the worst (when earnings have collapsed). Buying a cyclical "because its P/E is low" is often buying the top.

Types of Positions

Long

A long position is an investment in a share or other financial asset in the expectation that its price will rise. In other words, an investor with a long position expects to profit as the price goes up. Long positions are standard in stocks and other financial assets.

Short

A short position is an investment in a share or other financial asset in the expectation that its price will fall. In practice, we borrow shares from our broker, sell them today and later buy them back (cheaper, we hope) to return them. If we sell at $100 and buy back at $70, we make $30 a share.

Long and short are not symmetrical, and it is important to understand why:

Fig. 15Long and short: two different risks

	Long	Short
We make money if	The price rises	The price falls
Maximum gain	Unlimited	100% (if the stock goes to zero)
Maximum loss	100% of what we put in	Unlimited
Dividends	We receive them	We pay them
Extra costs	None	A fee for borrowing the shares
Time is	On our side (good companies grow)	Against us (the market rises over the long run)

That is why shorts are used mainly as hedges, and in smaller sizes than longs.

An example portfolio

If our portfolio has 10 positions and we want diversified sector exposure focused on US mid and large caps (at least $1B in market capitalisation), it might look something like this:

• 5 long positions (3 growth stocks, 1 defensive stock and 1 cyclical stock)
• 5 short positions (2 value stocks and 3 cyclical stocks)

Fig. 16A 10-position portfolio

This way we profit from the rise of growing and defensive sectors while protecting the portfolio against a fall in cyclical and value sectors; and at the same time we profit from the fall of cyclical and value sectors while our longs in growing and defensive sectors cover us.

Two useful concepts come in here: gross exposure (longs plus shorts, how much money we have "in play") and net exposure (longs minus shorts, how much a move in the whole market affects us). With the same 10-position portfolio we can express different views of the market just by changing the weights:

Market view	Longs	Shorts	Gross exposure	Net exposure
Neutral	5 × 10% = 50%	5 × 10% = 50%	100%	0%
Bullish	5 × 14% = 70%	5 × 6% = 30%	100%	+40%
Bearish	5 × 8% = 40%	5 × 12% = 60%	100%	−20%

With zero net exposure, what we make or lose depends almost entirely on having picked the right companies, not on where the market goes. It is the purest version of "knowing what you own and why you own it".

7. OPTIONS: WHEN THEY MAKE SENSE

Warning: options are an advanced instrument. You can lose 100% of what you put in within a few weeks even if you get the stock's direction right. If you are starting out, read this section to understand how they work, but do not use them until you have mastered everything above.

What an option is

An option is a contract that gives you the right, but not the obligation, to buy (a call) or sell (a put) a stock at a set price (the strike) until a specific date (the expiry). For that right you pay a price, the premium. In the US, each contract covers 100 shares, so a $1 premium actually costs $100 per contract.

The key difference from a share: options expire. You can hold a share for twenty years waiting for the market to prove you right. An option has an expiry date, and if by then the stock is not where you need it, the option is worth nothing and you lose everything you paid.

An example: the stock rises from $100 to $120

A stock trades at $100. You think it will rise strongly over the next few months. You have two options (no pun intended):

• Buy the stock at $100.
• Buy a call with a $110 strike expiring in 3 months, which costs $1 (that is, $100 per 100-share contract).

The call gives you the right to buy the stock at $110 until expiry. If the stock trades at $120 at expiry, you can buy it at $110 and sell it at $120: the call is worth $10. You paid $1, so you make $9 a share, 900%. The stock, in the same scenario, has made 20%.

With $1,000 in each alternative (10 shares, or 10 call contracts), the result at expiry depending on where the stock ends up is this:

Price at expiry	10 shares ($1,000)	10 calls, $110 strike ($1,000)
$90	−$100 (−10%)	−$1,000 (−100%)
$100	$0	−$1,000 (−100%)
$105	+$50 (+5%)	−$1,000 (−100%)
$110	+$100 (+10%)	−$1,000 (−100%)
$111	+$110 (+11%)	$0 (break-even)
$115	+$150 (+15%)	+$4,000 (+400%)
$120	+$200 (+20%)	+$9,000 (+900%)

Fig. 17$1,000 in the stock or $1,000 in calls

Look at the $110 row: the stock is up 10%, you got the direction right, and you have still lost everything on the calls. To make money with an option it is not enough to get the direction right: you have to get how much it rises and when. If the stock reaches $120 the day after expiry, your call no longer exists.

Why options lose value over time

Before expiry, an option is worth more than what you would make by exercising it today, because something can still happen. That difference is its time value, and it evaporates every day that passes (professionals call it theta), faster and faster as expiry approaches. If the stock stands still, your call loses value every day even though nothing has changed.

The other factor is implied volatility: the more the market expects the stock to move, the more expensive the option. Before earnings, options are usually very expensive, and right after the results they suddenly get cheaper. It is very common to call the direction of an earnings report correctly and still lose money on the call, because the stock moved less than the option's price already assumed.

When to use options

Options make sense when they fit what you want to express. These are the sensible uses:

Goal	Strategy	Maximum loss	Example
Bet on a big move with a date	Buy calls (or puts if you expect a fall)	The premium paid	You believe results in 6 weeks will surprise strongly to the upside
Protect the portfolio	Buy puts	The premium paid, like insurance	You have large gains and fear a specific event in the next month
Earn income on shares you already own	Sell covered calls	You give up the upside above the strike	You own 100 shares and accept selling them 10% higher in exchange for a premium
Buy a stock you want more cheaply	Sell puts with the cash to buy	Having to buy the stock even after a big fall	You want the stock at $90 and collect a premium while you wait

They fit trading from section 2 particularly well: a dated catalyst, a specific thesis and a maximum risk known in advance. Unlike borrowing to invest, with a bought call you can never lose more than you paid, and nobody can margin-call you.

And when not to use them:

• To invest for the long term with no date. If your thesis is "this company will be much better in 5 years", buy the stock. An option forces you to get the timing right, and the market rarely respects yours.
• To "multiply" an idea you are not sure about. A call's leverage amplifies mistakes too: −100% is far more common with options than with shares.
• Selling calls without owning the shares ("naked" calls). It is like a short: the loss has no limit.

If you want to see a real case of how a call behaves in practice, with its multiples and the point at which it stops behaving like an asymmetric bet, I tell it in this article about a Tesla call. And if you are interested in the side of whoever sells options for income, see the article on MSTY.

8. BEFORE YOU BUY

Before opening any position, you should be able to answer each of these questions in one sentence:

1. Is this an investment or a trade? And if it is a trade, what is the catalyst and when does it arrive?
2. Why this company and not its rival? (EPS and sales growth against the sector)
3. Are its margins improving or deteriorating?
4. How much room is left to grow? (market share against addressable market)
5. What growth does its P/E price in, and is that reasonable?
6. If it is part of a theme, which stage of the cycle is it in?
7. What would have to happen for me to be wrong, and how would I find out?
8. Is it redundant with something I already own, directly or inside an ETF?
9. How much conviction do I have, and does the position size reflect it?

If any answer is "I don't know", it is not yet time to buy.

In short, investing in stocks calls for a structured approach: building a portfolio, generating investment ideas, managing risk and carrying out solid fundamental analysis. With this knowledge and some practice, investors can make better-informed decisions and potentially improve their results.

"In the short run, the market is a voting machine but in the long run, it is a weighing machine." — Benjamin Graham