In Part 1 of our discussion, I explained why constantly reading as much as possible is a crucial part of every investor's education. As you work your way through lots of financial-information resources and annual reports, you'll eventually find companies that offer great investment appeal and merit investment capital. But before you pull the trigger, make sure you do one thing. You've done the reading. Now you need to start writing.
If you can't write it down, you don't understand it
Remember when your English teachers made you write essay after essay? If you were hoping that a career in investing would take you away from such tasks, you and your portfolio might be in for a rude awakening.
We've all heard Warren Buffett say that before you act on an investment you're considering, you should be able to write your reasons down in a couple of sentences. The point is that if you can't easily express what the business does and how it makes money, then you should avoid it.
In short, writing out your investment thesis ensures that you understand the business, requires you to quantify why the investment makes sense at the current price, and prevents you from selling too early at the first sign of trouble.
So, do you understand it?
Buffett can easily express what interested him in Berkshire Hathaway (NYSE: BRK-A ) (NYSE: BRK-B ) and Coca-Cola (NYSE: KO ) . You should know how to do the same. Being able to write out your reasons for investing in a business demonstrates that you understand that business. If you understand it, you'll be able to base your investment on facts, and you'll have better confidence when you invest.
The same principle holds for valuation. If you can't value a business, you shouldn't be investing in it. And again, that's why you put pen to paper. You can value a business only when you know what it does and how it earns it profits. When you write out your investment thesis, you'll sort those things out, and you'll inevitably figure out whether the business is undervalued, fairly valued, or overvalued.
Ignore the noise
One of the most psychologically painful experiences for an investor is to sell a stock for a loss, only to see the price rocket up shortly afterwards. But by knowing your investment cold, you severely reduce the likelihood of jumping ship at the first sign of trouble. Analyst upgrades or downgrades won't easily sway you.
Again, the writing process will help you. It builds on itself. In addition to helping you determine the worthiness of an investment, it will also help you know when to sell. Sound analysis will tell you whether a stock is no longer undervalued, or whether something has happened that permanently reduces your stock's intrinsic value. If you take a loss here, that's OK. Your winners will still probably outnumber your losers, as long as you're making decisions based on sound analytical research.
Do it your way
All investors have their own unique investing process. We all comprehend points of data differently. What must be the same is that before you invest, you understand what you're getting yourself into. Buying what you understand, and getting it at a fair price, is always the goal, and maintaining good reading and writing habits regarding your investment decisions will help keep you focused.