Two guiding principles should lead your stock investing decisions. First, you will make mistakes that will result in the loss of money. Second, accounting and business models constantly change. So, you will need to adapt and develop new mental models. In a recent interview, Warren Buffett discussed how people's views of Coke and Ketchup are changing and how it affects their business valuation.
What results from the two principles is powerful. If you come to terms with the fact that you will lose money by investing in stocks, you will become a careful, prudent investor - one that thinks carefully before purchasing a stock in a company. And if business knowledge is a constantly evolving field of study, a growing knowledge base is fundamental to stock investing. For example, when I bought a stock in RAIT Financial, I though I had a pretty clear understanding of the company's balance sheet. Yet I failed to understand how GAAP accounting treats preferred stock. Read more in "What RAIT Financial Taught Me".
In the book The Education of a Value Investor by Guy Spier, I learned that great investors use a simple tool: a checklist. Here are a few of Guy's checklist items: Are any of the key members of the company's management team going through a difficult personal experience? Is this company providing a win-win for its entire ecosystem? Is this stock cheap enough (not just in relative terms)? And am I sure that I'm paying for the business as it is today - not for an excessively rosy expectation of where it might be in the future?
A few days I ago, my brother and I sat down for lunch with a savvy real estate investor in his forties. He told us that his dad used to make horrible, costly investing decisions. In the middle of 2007 (a few months before the Great Recession), his dad purchased homes as investments. And in the late 90s his dad bought stocks of tech companies. Concluding that any business endeavor his dad would invest in was bound to fail, he jokingly said, "If my dad entered the morgue business, people would stop dying."
The moral of the story is that if you hear or read about an investment opportunity that was thought of or written by someone else, the word "opportunity" should be omitted.
If you are over 25 years of age, you probably know by now the difference between a straightforward relationship and a complicated one. In the former you meet someone, you immediately have interesting topics to talk about, you share common interests and shortly after the first date, both sides are genuinely interested in the well being of one another. Anything outside of that, I define as a complicated relationship.
What is true in good, healthy relationships is also true in stock investing: you need to feel comfortable about the business in which you invest in and you need to feel somewhat assured that you can understand where the company (or person) will be over the next five years. Surprises and untold truths, in both business and in real life, work against you.
For the reader who is uninterested in my relationship analogy, I would simply offer to read the annual report of Costco Corp., and GE. The former report is straight forward and can be easily understood. The latter report is a complicated one. And Capital markets have voted clearly in the simple v. complicated debate: Costco stock increased from $110 to $199 over the past five years while GE's stock declined from $25 to $15 over the same period.
I associate the word rationality with having a reason. If you invest in the stock of a business, you need to have a reason. Perhaps you did some math and figured that the price of the stock is much lower than its value. Perhaps you researched the consumers of the business and concluded that the demand for the product or service will exponentially grow in a few years. Reason rests where study, observation and knowledge live. Make sure these three factors are the ones driving your investing decisions.
Unless you think carefully what it is that you would like to achieve by investing in the stocks of publicly-traded companies, you will likely find yourself attempting to achieve someone else's goals. You may hear that your friends earned a fortune by investing in Bitcoins, and your goal will be to beat them at their own game. Another example of the dire consequences of not having clear goals is that you will not know when to stop and make bets that you cannot afford to lose. Very few people become successful that way. I have two goals in stock investing. First, my goal is to beat the S&P 500 index over a five-year period. Second, to grow my knowledge of finance by studying businesses, industries and management.
Your list of stock investing habits should grow in time. Since I started to write about stock investments about a year ago, I developed the following new habits: (1) I now sift through the operating financials of 15 companies each week; (2) I read two to three annual reports each week; (3) I study and refresh my memory on investment concepts every month; and (4) I read about an unknown industry on a monthly basis.
In Flow: The Psychology of Optimal Experience, Mihaly Csikszentmihalyi defines the common characteristics of an optimal experience as:
"A sense that one’s skills are adequate to cope with the challenges at hand, in a goal-directed, rule-bound action system that provides clear clues as to how well one is performing. Concentration is so intense that there is no attention left over to think about anything irrelevant, or to worry about problems. Self-consciousness disappears, and the sense of time becomes distorted. An activity that produces such experiences is so gratifying that people are willing to do it for its own sake, with little concern for what they will get out of it, even when it is difficult, or dangerous."
It is an accurate description of how investing in stocks has affected my well being. May you have the same experience.