Methodology: Part 3. Don’t Be Stupid

January 18, 2011 § Leave a comment

This is my series on how I decide to buy what I buy
Part 1. Part 2.

Ok, so we got the “is it selling cheap” down and the “what is the intrinsic value” down and we have talked about margin of safety and all those good things. But it’s still not time to buy. Being wise about your investments is more to do with keeping your emotions in check and making sure that you aren’t doing really stupid things because of any kind of psychological reasons then it is making sure everything fits into a numbers box.

This is probably why I am more inherently attracted to Charlie Munger than I am Warren Buffett. Sure Buffett is the granddaddy can-do-crazy-math-in-his-head super investor, but Charlie Munger is good ol fashioned don’t-be-a-one-legged-man-at-an-ass-kicking-contest common sense kinda guy. In fact the best thing I have yet to read on investment has come from a lecture he gave at Harvard in 1995 called The Psychology of Human Misjudgment.

So I think the most important thing you can do once you think something may be a good investment is to have this emotional check list that you go through. Give the investment some time. Think it over. Ask questions. Plot out the best case, good/likely case and worst case scenario and see if you could live with the worst. Be really honest about whether you are doing this because it would be risky not to as opposed to any number of outside factors, like herd mentality or whether you say things like “man I’ve put so much time into this. It’s gotta pay off. I’ve worked so hard.” No. Be zealous about staying as objective and conscientious to the context as possible.

I separate my questions into two chunks. Chunk one is more technical stuff:
-is there stable market share? As in, is there enough ways that they can get money and do what they do
-are they dominant or secondary in their industry
-do they have a strong brand? Is the brand being factored in to the price. Are you ok with that? (think Apple. Or Netflix. Or Coke.)
-do they use the power of the network/social media. Can they fit into a world dominated by google/twitter/facebook. Or does it not matter to their industry.
-Do they change fast. If yes, that’s bad. Don’t give yourself big hurdles to clear.
-Can they change their price, or are they in a dead heat with competition
-Do they have a moat beyond a brand identity?
-Do they have high inside ownership (I love inside ownership. Nice for them to have skin in the game. This is why I love Nordstrom as a company. Too bad they are always so freaking fairly priced. Man I should have bough in 08. Huge regret. Good lesson to learn. Trust your checklist.)

The second grouping of questions is…um…slightly less technical.
-Are you being stupid?
-Are you overconfident?
-Dividend? If not, justify your buy
-Is your margin of safety high enough?
-Are you buying for your own reasons, or because of someone else?
-Are you relying too much on past performance? (Just because they have a ROE of 20% for 5 years or have grown x amount of time in no way means they are a good buy.)
-Have you daydreamed about what living with the worst case scenario would be like?
-Is the stock falling or fallen. Remember the National Bank of Greece
-is this a concept stock or are they actually doing something. Don’t fall for the TSLA foil. (hey-o! see what I did there?)
-can you hold this for 3 years? Cuz you should. Now obviously, true value could be realized in 3 days, at which point you would sell. But it usually takes about 3 years for all the shoes to drop. Their hitherto unseen awesomeness is either revealed or you are revealed for not doing your homework.

The psychology of human misjudgement is something I am going to dedicate my investing life to. The emotional side of things is that important. Right now what I’m fighting against is the “omigosh the market is crazy rising! Buy buy buy!” Mix that with my youthful exuberance and my bias feelings of “hey, I’m the protagonist of this story. Of COURSE my portfolio is going to be awesome!” and you’ve got a recipe for crappy returns and buying things too expensive. So that explains why all is quiet on the CAPS front for me these days.

And I hope to update my emotional/common sense checklist every once and a while. I’ll let you know as I do.

*I don’t own anything I mentioned. Especially TSLA. Sell some cars, then we’ll talk.

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