This article first appeared in the Australian Financial Review on October 04, 2017
Investing is a craft best practised by those who can bury their emotions and make decisions in a perfectly rational manner. As Benjamin Franklin said: “An ounce of prevention is worth a pound of cure.” Since you and I are human, though, we’ll have to settle for doing the best we can to silence our innate tendencies to be greedy and fearful.
Few investing decisions are more prone to emotion, and thus bad judgment, than the decision to cut back or stick with a stock that has underperformed.
But while there are steps investors can build into their process to help manage the selling process as unemotionally as possible, there is a better path – making better buy decisions in the first place.
Even a rigorous investing process executed by the most savvy team will still make mistakes – it comes with the territory when investing in shares. Based on my experience, though, there are some vital steps investors can take to reduce the number of bad outcomes.
Understand what you’re buying
If this sounds obvious, think again. I’ve met plenty of investors over the years who invested in a company based on nothing more than a tip from a mate, broker or barber.
Sometimes these investors only know the ticker symbols of the companies they bought and not even the actual names, let alone how the business makes money (or, often in these situations, how it incinerates shareholders’ capital).
It’s not just retail investors who can sometimes get out over their skis, though. A long-time colleague of mine who works in another part of our parent company (The Motley Fool) once found himself live on CNBC with another guest who tipped a ticker symbol but, when asked by the host, could not actually name the business. Don’t be that guy.
Run your ideas through a checklist
Checklists are a very useful way to quickly and methodically run new ideas through an investment process. I’m fond of running new ideas through a brief checklist of both positive and negative traits to get a sense of whether a potential investment is worth further digging.
On the positive side, traits that point towards positive long-term outcomes include whether a business is founder-led, gaining share of a growing market, has a net cash position or has a demonstrably superior product or service.
On the negative side, I am cautious of recent profit downgrades, rising debt, falling sales, customer or supplier concentration risk and uncontrollable externalities that could sink the business(such as gyrating commodity prices or a heavy-handed regulator).
Write down your rationale
Forcing yourself to write down why you’re making an investing decision before buying has a way of cooling your blood. And don’t sweat a 50-page treatise – for an individual investor, even a couple of paragraphs detailing your thinking upfront will ground your thinking.
Outline your reasons for selling – in advance
While you’re going to the trouble of writing down your investment case, include why you would later sell. Maybe if it’s if the company begins to lose market share, a founder leaves, the valuation reaches a certain level, or whatever else fits your process. Simply having those notes in hand when trials come later will help you to remain rational.
Investing mistakes are unavoidable despite the best of checklists and processes, if for no other reason than they tend to be backward-looking and we humans are unable to imagine every possible failure.
I’m reminded of another pearl from Franklin: “I didn’t fail the test, I just found 100 ways to do it wrong.” Nonetheless, the ounce of prevention required to avoid a pound of cure is a small price well worth paying.
Joe Magyer is the chief investment officer of Lakehouse Capital. This article contains general investment advice only (under AFSL 400691).