personal finance

Before You Invest in the Stock Market, Answer These 3 Questions

Twenty/20

You may feel tempted to take part in the action when stocks soar, but financial experts recommend taking a pause before jumping in.

When it comes to investing in seemingly "hot" stocks, it can be easy to get caught up in the hype and the fear of missing out. But it's important to truly understand how difficult it is to successfully stock-pick. It's risky and generally not a reliable way to build wealth.

That's why "there's some standard principles that one should obey before considering investing in individual stocks or any one individual particular investment," Douglas Boneparth, certified financial planner and president of Bone Fide Wealth, tells CNBC Make It.

If you're willing to take the risk, here are three questions to ask yourself before buying any stock.

1. Can I afford to lose this money?

First, assess whether you're spending an amount you can afford to lose. Again, remember that financial experts warn against trying to pick stocks and time the market. It's extremely difficult to outperform the market, and even harder to do so consistently over time.

"One of the golden rules here is never invest more than you're willing to lose," Boneparth says. "Be mindful of how much you're putting at risk."

While you may dedicate some funds to individual stocks, consider putting the bulk of your investments in index funds, which provide automatic diversification and are typically low cost. Index funds tend to outperform actively managed funds as well.

Take it from legendary investor Warren Buffett: "Consistently buy an S&P 500 low-cost index fund," he told CNBC in 2017. "I think it's the thing that makes the most sense practically all of the time."

2. Is it a great business?

Second, do your due diligence on the business you're buying stock in.

"It's one thing to just like a stock or because you use it and you believe in it," Boneparth says. "It's another thing to actually take a minute and understand the business that you're investing in."

Before parting with your money, look up the business' annual reports and research analysts' reports. You can also listen to the company's earnings calls. It's important to educate yourself on things like how the business makes its money, how much cash it has on hand, what its margins are and who its competitors in the space are.

Though "it gets very financial, this is a great way to understand what is actually taking place with the business," Boneparth says.

Even Buffett does his homework before investing. He looks for long-term value and aims to understand the companies he invests in. "Intelligent investing is not complex, though that is far from saying that it is easy," Buffett wrote in his 1996 annual shareholders' letter. "What an investor needs is the ability to correctly evaluate selected businesses."

Don't just invest in what seems popular at the time, such as so-called meme stocks, like GameStop and AMC Entertainment, without doing your own research.

"Just because everybody else is doing it, it doesn't mean it's right for you," Boneparth says. "Just because you saw a rather successful short squeeze, don't confuse the novelty of that situation with something that will repeat itself over and over again."

3. How does this investment fit in with my overall strategy?

Last, consider how investing in a particular stock relates to your overall investment strategy.

"You don't want to risk more than you're willing to lose, but also, understand how much you're putting in individual stocks or an individual stock relative to the main part of your investment portfolio," Boneparth says.

While this allocation depends on an investor's personal circumstances and can vary, a general rule of thumb is to allocate 5% to 10% of your portfolio to individual stocks or other alternative asset classes, Boneparth says. The rest should consist of less risky investments, like passive index funds that track the S&P 500.

"Whether that's individual stock picking or other alternative asset classes that you're researching or feel like there's an opportunity to make money in, [it's] an amount that's not going to blow up your entire strategy if you're wrong, and might actually add a little performance if you're right," Boneparth says.

However, investors should remain very disciplined in regard to the majority of their portfolio.

"Perhaps buy and hold and let the market do its thing," Boneparth says. "Just be mindful."

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