Legendary mutual fund manager Peter Lynch once said that people will do more research on a $1,000 refrigerator than they will before they spend $10,000 on a stock.
One of the reasons that investors don’t spend very much time analyzing their stock purchases is because it’s much easier to invest based on a story. We love to tell ourselves stories about potential growth, new products or dynamic CEOs and invest on those narratives.
But narratives don’t work over the long run so you have to ask yourself some serious questions when analyzing a stock investment. Here are some important questions to consider.
What is your edge on this investment?
A long-term time horizon? Small-cap stocks that aren’t covered by Wall Street research analysts? Individual investors have one huge advantage over Wall Street. We have the ability to be patient. We don’t have to make decisions that affect our monthly or quarterly performance on a consistent basis.
We can make decisions that are based on years or even decades instead of trying to outperform on a weekly or monthly basis. This allows individual investors to look for investments that may be out of favor or off the radar of the mainstream research analysts.
Have you built into your analysis the fact that you could be wrong?
What are your data points that will tell you that you made the wrong decision on a stock? And what is the time horizon that you will give yourself to see if your thesis will play out correctly? Knowing this ahead of time can give you a better idea as to when you should sell a losing investment or hold on for the long-term. Buying with a margin of safety gives you the ability to be wrong about some of your projections or analysis and still come out on top in the end.
Have you looked at research that goes against your own opinion?
In today’s information age, it’s incredibly easy to find research or opinions on prospective or current investments. You can find an expert on Twitter, in the news or through a blog that completely agrees with your line of thinking. These can all be very useful tools for gathering information.
But you also have to look for analysis that refutes your strongly held opinions. Even if you don’t agree with the opposing views, it helps to see both sides of every trade or investment. This allows you to make informed decisions and weigh the various probabilities of your analysis being right or wrong.
Have you gone through your investment checklist?
A business with a “moat” or long-term competitive advantage
A company that he understands
A solid management team that he can trust
Little to no debt in the business
Consistent operating results with a good return on equity
And finally a margin of safety built into his analysis in case he is wrong
Obviously, Buffett’s process is much more involved and complex than this list, but he can use this as a starting point for further research. You should be able to spell out your investment philosophy into a handful of overarching rules for a simple checklist that you can use to determine any red flags or the need for further research on a stock.
A consistent process is also important when picking stocks. The variables can change but staying consistent in the investments you are looking for allows you to focus on process over short-term outcomes which can lead to much better long-term results.
Have you thought about a range of possible future outcomes?
Investing is more of an art than a science. It’s impossible to correctly predict what will happen next with the financial markets and the individual companies that make up those markets. That’s why you will never be able to forecast with precision. There will always be unknowns so you have to assume a wide range of possibilities. You can then use those ranges and possibilities to assign some probabilities to your outlook. Investing requires a leap of faith, but as John Maynard Keynes told us, “It’s better to be roughly right than precisely wrong.”
These questions are just a starting point for further research, but hopefully they will help keep you from making large-scale mistakes and irrational short-term decisions that can hurt your portfolio.
Readers: What’s your process before you buy a stock?
About The Author: Ben covers investments, personal finance and how our behaviours affect our financial decisions at A Wealth of Common Sense.
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