Selecting the right companies to invest into is very hard and the decision shouldn’t be taken lightly.

When you invest in the stock market, more often that not, you will be tempted to buy companies or products that you don’t truly understand. Either a salesman from a bank will tempt you to buy one of their in-house products, or your brain will tempt you to buy something that your brain finds ‘sexy’.

Psychologically, when your brain is faced with a difficult question, it starts answering different and easier questions, and in many cases, you will not even notice. For example, faced with the question: “Is investing in this company most likely going to be a profitable investment?”, your brain starts answering the following questions: “do I know this company?”, “do I like this company?”, “do I know other people investing in this company?”. The results can be disastrous.

So you need to resist temptation, and focus on the only question that counts: “Do I understand the business of this company well enough so that I am reasonably confident that it is going to be a good investment?”. The only way to answer this question is by doing the following things:

• check the products and services sold by the company and whether you understand them
• analyse the historical financial performance of the business e.g. Revenue growth, Profit margin, Earnings per share, Debt level etc
• analyse the business climate and industry in which the company operates. If you don’t understand whether the industry is growing, and who the existing competitors are, and what the substitute products might be, then you should probably not buy this individual stock
• understand the quality and track record of the management team.

This analysis is obviously difficult and very time consuming, and that’s why people who don’t have the time, nor the competence to do it themselves, shouldn’t buy shares in individual companies directly.

Therefore, it is much safer to buy an index made of 20, 30 or even 50 companies, because the risks are spread over a large number of businesses, and the question that counts now is easier to answer: “Which stock market or region of the world do I believe will develop well in the future and provide a reasonable return on investment?”.

If you are in Germany and buy a DAX index, then you are investing your savings in the future of the 30 largest companies in Germany. You trust that large listed German companies will do well in the future, as they have done in the past. And you understand that even if some of the companies in the DAX do not perform so well in the future, the others will. And that’s enough to provide a good return on investment.