Use Scientific Thinking
The most important skill for any investor to develop is temperament. No amount of research, know-how, data, or analytical capability can overcome the tendency of investors to act on emotion before reason. This is part of the human condition. One general area where I think all investors can use a reminder is in scientific thinking. As you consider any investment decision, ask yourself: Are the conclusions I draw actually based on observable facts? How were these facts collected? Are these facts applicable to the situation I am considering? What is the likelihood that my conclusion, however well-reasoned, is wrong? Investing is always, at least a little bit, about trying to predict the future. This is difficult enough with good data and sober analysis. It’s impossible when an investor ignores reason and evidence. Choose your news sources carefully and give yourself time to digest the latest data before you act.
Consider the Shareholder
Knowing how a company treats its shareholders is essential to understanding how it might perform as an investment. One measure of that is whether a company dilutes its shares or pays dividends (or does neither). Here, a useful number to monitor is the number of shares outstanding, which companies report on a comprehensive income statement as basic shares and fully diluted shares. The latter paints the truest picture and is important because dilution reduces the size the portion of the company you own and the earnings per share, all other things being equal.
Major sources of dilution include secondary offerings to raise capital, acquisitions using equity as part of the purchase price, and stock-based compensation for corporate employees. These sources of dilution are all legitimate under the right conditions. Used incorrectly, these dilution techniques can greatly reduce the value of your shares. Making sure management is using that capital or dilution for the good of the shareholder fundamental when looking for a new stock to add to your buy list.
Keep Emotions in Check
Behavior economics (the effect of human emotion on financial decisions) is one of the most valuable topics for aspiring investors to study. I’ve written often that time frame and temperament are among the big advantages we have as individual investors. Our human brains are built to help us survive in a certain set of conditions, but make it difficult to make complex financial decisions. Know your own weaknesses. Being able to identify psychological biases and mental traps is critical both to avoiding mistakes and to recognizing when you’ve made one.
Keep Costs in Check
My economics professor in college used to say that “costs are destiny,” and the more I’ve studied investing, the more I’ve learned how right he was. Understanding a company’s cost structure can tell you about its underlying economics, competitive position, and what it will look like at different points in the economic cycle. Does a business require heavy upfront investment that keeps would-be competitors out of the market? Do its costs grow with revenue, or do its margins skyrocket after a certain point? Will managers be able to “scale down” costs if demand suddenly tanks? Analyzing the cost structure will give you the answer.