Awhile back, we discussed five ways to be a horrible investor. Now let's flip the script and discuss three quick and easy ways to be better investors.
1. Stay in your circle
Chances are you already know you should only invest within your "circle of competence." However, it's easy to stray from your circle toward the fad of the day -- especially when you feel like everyone else is getting rich by buying Chinese stocks like Rule Breakers recommendation Baidu (NYSE: BIDU ) .
Here's a quick and easy solution. Take out a piece of paper. Draw a circle and list all the industries you are very familiar with -- where you understand how the businesses make money, which companies have the most market share and why, and their competitive dynamics.
Keep in mind that everyone has their own circle of competence. I personally feel comfortable analyzing financial services companies like Countrywide Financial (NYSE: CFC ) . But I've read entire annual reports of energy companies like ConocoPhillips (NYSE: COP ) and felt like I just read something written in Greek. Until I can put energy companies in my circle, I will refrain from investing in the entire sector.
Similarly, every time you get interested in a stock, pull out your trusty diagram and check to see if it's in an industry in your circle. If it's not, you have two options. Either spend the time and effort to learn enough about the industry to put it in your circle, or simply don't invest.
This should help you avoid getting burned on that "can't-miss" Eastern European gold mine stock that was so far out of your circle you'd need a telescope just to see it.
2. Manage your managers
There's something you should know about public companies: If they want to, managers can take advantage of shareholders very easily. Many boards of directors serve as the CEO's rubber-stamp committee, so it's easy for management to pay themselves too much and dilute shareholder profits through generous stock options and other tricky tactics.
That means it makes all the sense in the world for shareholders to get a feel for management. Some companies, like American Express (NYSE: AXP ) , Inside Value selection Berkshire Hathaway (NYSE: BRK-A ) , and Leucadia (NYSE: LUK ) have managers renowned for doing right by their public shareholders. If you'd invested in shares of any of those companies over the past five years, you'd have made money almost regardless of your timing.
So how does one get a good feel for managers? Track record and reputation are the best place to start. A high percentage of insider ownership usually indicates shareholder-oriented management. On the other hand, watch out for situations where special share classes with super-voting rights can effectively entrench management without a strong ownership interest. I'd also watch out for egregious options plans and salary structures.
Last, read the transcripts of a couple of conference calls and some shareholder letters. Does management hold itself accountable? Do managers take the blame when they drop the ball, or do they simply shift the blame to factors like the weather? After awhile, you should get a sense of whether these are people who will make you money.
3. Record your reasoning
Before you invest in a company, take out a piece of paper or open your word processor and finish this sentence: "I am investing in (name of the company) at the price of (current market cap) because ..."
You'd be surprised at how many bad investments this could deter. For example, I think many investors would stop in their tracks if they actually took the time to write "I am investing in Chipotle (NYSE: CMG ) at a $4 billion market cap because I think they have delicious burritos." After all, as my Foolish colleague Morgan Housel astutely noted, does a delicious burrito equate to a delicious stock?
So there you have it, three quick and easy ways to improve your investing process, and hopefully your investment returns. Good luck!